Baby Steps for Reducing Risk

Investors can take smaller steps to reduce a portfolio’s risk profile without making a sweeping overhaul

Amy C. Arnott 11 August, 2020 | 1:22AM
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Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

If the current market environment has you on edge, you’re not alone. In addition to the human toll of the coronavirus pandemic, financial uncertainties abound. The market dropped 23.5% from its peak on Feb. 20 through March 31, while volatility has spiked to levels not seen since the global financial crisis. The economic outlook is equally uncertain, with expert predictions ranging from modest drops in gross domestic product to more-catastrophic downturns.

With all of this uncertainty, jittery investors might be tempted to sell off their investments and take refuge in cash. That’s probably a mistake, as it puts emotion firmly in the driver’s seat. Instead of making a rash and sweeping overhaul, consider taking the following small steps to reduce a portfolio’s risk:

  1. Get with the plan (or devise one).
  2. Do a risk check.
  3. Take charge.

Get With the Plan (or Devise One)
Having a long-term plan is key to improving your odds of success over time. If you had a target mix of stocks, bonds, and cash in place before the crisis, there’s no reason to make major changes based on recent events. (One exception would be if you’re worried about short-term job security, in which case you may want a slightly larger cash buffer than usual: maybe 12 months’ worth of living expenses instead of the standard six-month guideline.) Overall, your asset mix should be based on your individual goals and needs (including time horizon, risk tolerance, and so on) instead of shorter-term market expectations.

Even institutional asset managers who attempt to implement tactical asset-allocation strategies (in other words, shifting between stocks and bonds based on changes in their economic outlook or other factors) have almost uniformly failed to make that work. The risk of selling after stocks have already declined means that you lock in lower returns and risk missing out on the eventual upturn. Indeed, we’ve already seen a few brighter days since the market’s near-term low on March 23. Missing out on even a few positive days can dramatically depress returns over time.

To keep your portfolio’s asset mix in line, you might even need to rebalance by shifting more assets into stocks now that equity values have dropped. If you started the year with a 60/40 asset mix, for example, it probably looks closer to a 55/45 mix of stocks and bonds at this point. We generally advocate rebalancing a portfolio at least once a year or whenever an asset class has drifted significantly higher or lower than your target level. Rebalancing when things are more than 5% above or below your target levels is a good guideline.

Of course, that’s easier said than done. But most academic studies have found that rebalancing tends to reduce a portfolio’s risk level over time--and can also improve returns by forcing you to buy low and sell high after a significant market move.

Check for Major Risks
If you enter your portfolio into Morningstar’s Portfolio Manager, you can get a detailed view of your portfolio’s diversification and risk profile with our Portfolio X-Ray tool, including concentrations in individual stocks, sector exposure, credit quality, and interest-rate risk. Here’s how to dig into these potential risk factors.

Concentrated Stock Holdings
As a rule of thumb, we generally advise limiting any exposure to any single stock to less than 10% of your total assets, particularly for stock issued by your employer. If you receive equity awards such as stock options or restricted stock units as part of your total compensation package, your stock position might have ballooned over time. And it can be tough to prune back large holdings without realizing significant taxable capital gains. The silver lining from the recent downturn is that whatever unrealized gains you had before have most likely shrunk. This creates an opportunity to trim back holdings without taking as much of a tax hit. You can also do “bracket planning,” which involves realizing capital gains over time to avoid pushing yourself into a higher bracket for capital gains. (Consult a tax advisor for more details on your specific situation.)

Concentrated Sector Exposure
It’s also worth checking up on your portfolio’s sector exposure to make sure you’re not overloaded on any particular area. Our Portfolio X-Ray report shows the sector exposure across your portfolio. You can also compare each sector’s weighting to a market benchmark. Consider making some tweaks if any particular sector is way above or below the benchmark in a given sector. In the most recent downturn, sectors such energy and financials have been hit particularly hard, while healthcare, technology, and consumer defensive stocks have held up a bit better.

Credit Quality
Credit quality is another potential risk worth digging into for fixed-income holdings. As investors worried about the economic side effects of the coronavirus, high-yield bonds were hard-hit. These bond-price declines were exacerbated by liquidity woes, as high-yield fund managers were forced to sell into weakness to meet redemptions. As a result, the average high-yield bond fund lost 12.7% in the first quarter of 2020. Lower-quality municipal bonds have also suffered.

The upside of these losses is that credit spreads have widened, meaning that investors are being compensated with higher yields in exchange for taking on credit risk. But high-yield bonds have historically been significantly more volatile than other fixed-income securities and have also suffered deep losses during economic downturns. In a severe and/or prolonged economic downturn, corporate credit quality would continue deteriorating. That, in turn, leads to a higher risk of bond defaults. Risk-averse investors should probably favor investment-grade securities, such as higher-grade corporates, Treasuries, and mortgage-backed securities instead.

Interest-Rate Risk
As the Fed’s recent rates cuts have pushed interest rates even lower, longer-term bonds have rallied. The long-term government bond fund Morningstar Category posted total returns of 20.5% for the first quarter of 2020. However, interest-rate sensitivity can cut both ways. When interest rates reverse course, long-term government bonds have suffered quarterly losses of 13% or more. This volatility makes them difficult to use in a portfolio. Even if you’re not expecting interest rates to increase anytime soon, most investors will probably want to focus on short- and intermediate-term bond funds for core fixed-income holdings.

Control What You Can
With everything so uncertain right now, it’s easy to get caught in an endless spiral of “what ifs”--what if the death toll is higher than experts are predicting, what if the economy struggles for years, what if the market doesn’t recover for a long time, and so on Those are all important questions that we just don’t know the answers to at this point. But instead of getting caught up in financial anxiety, try to think about what you can control. There might be simple steps you can take--such as boosting contributions to your 401(k) plan or temporarily reducing your withdrawal rate if you’re already in retirement--that can improve your long-term outcomes and give you more of a sense of control.

At times of uncertainty, there is a temptation to do something. This action bias often crops up during market downturns, when investors can be tempted to make major changes to their portfolios to limit losses. But especially given the current high level of uncertainty, it’s better to focus on small steps to reduce risk instead of making bigger moves that could be counterproductive.

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About Author

Amy C. Arnott  Amy C. Arnott, CFA, is director of securities analysis for Morningstar.

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