Should You Reduce Your Investment Risk?

Investors panicked by stock market falls might be consider fleeing to cash, but ask yourself these five questions before derisking your investment portfolio

Christine Benz 8 April, 2020 | 9:12AM
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Investors are often slow to make changes to their portfolios, and that can be especially true during bull runs. When stock markets are soaring, it's tempting to leave well enough alone and let your winners ride. Inertia is a powerful force.

Given that, it's likely that many investors came into the current market sell-off with portfolios that were skewed heavily toward equities. Having borne the brunt of the market's recent losses, they may now be wondering whether to leave their investments in place to recover or take steps to reduce risk in their portfolios.

It's a tough predicament, and there aren't any one-size-fits-all answers; it depends on your time horizon and just how out of whack your allocations were coming into the market shock, among other factors.

Here are some of the key questions to ask yourself when deciding whether to take action:

How Soon do you Need Your Money?

How long until you need to access your money should be one of your key inputs when deciding whether you should derisk even after your portfolio has tumbled.

If you're still 10 or so years away from retirement, have a stock-heavy portfolio, and haven't been inordinately bothered by the market's recent volatility, it probably doesn't make sense to take steps to make your portfolio more conservative now. After all, the return potential of bonds and cash is very low, given today's low starting yields, so the less return you need to surrender to obtain peace of mind the better.

But what about if you had hoped to retire much sooner – within the next two to five years, for example? If your portfolio is almost entirely equities, that argues for taking steps to cut back on risky investments soon, even if it feels late in the game.

If history is any guide, stocks will likely recover; the market's recent strong performance has been encouraging. But it could take a while for stocks to mount a full recovery: since the Great Depression of the 1920s, bear markets (defined as a 20% drop in the market's value) have lasted anywhere from six months to nearly three years. And given the uncertainty of the current situation, stocks could fall further from current levels; it's not a given that they've bottomed.

How Flexible is your Retirement Plan?

Another variable in the mix is how flexible you're willing to be about your retirement date and your spending plan. If you're determined to retire in May 2021, for example, with no wiggle room about that date, then derisking is more urgent. On the other hand, if you're willing to delay retirement if it means that you'll be able to do so after the markets have recovered a bit and with a more comfy portfolio balance, derisking needn't be as big a priority.

Also consider your planned spending in retirement. If you're willing to reduce spending in the early years of retirement if it means you can retire on time, then there is less need to derisk a sizable share of your portfolio right now than would be the case for someone whose budget is more or less fixed. Generally speaking, higher-income folks have more leeway to cut spending in retirement than do lower-income workers, because a bigger share of their overall spending is discretionary rather than essential.

How Extreme is your Asset Allocation?

Once you've thought through your anticipated retirement plans, take a close look at your portfolio's current asset allocation. How much do you have staked in cash and high-quality bonds? Historically, and in the most recent downturn, these asset classes have done the best job of holding their ground during equity-market swoons. Thus, they've likely risen as a percentage of your portfolio even as your equity assets have declined.

If you expect to retire very soon, you'd want to have at least a few years' worth of portfolio withdrawals, and preferably even more, set aside in safer assets. The best portfolio plans use planned portfolio withdrawals to "right-size" allocations to the various asset classes.

Compare those targets with your current asset allocation (Morningstar's X-Ray tool can help with this). 

How Viable is your Plan Currently?

Another key consideration is the soundness (or "fundedness") of your retirement plan. How sustainable is it given your planned retirement start date and spending plan? If the answer is that it's very much on track and that you have more than you'll need for retirement, then you can put more weight on making changes that will provide you with peace of mind. If your portfolio is keeping you up at night amid the recent market volatility and you've saved more than you'll need in your lifetime, taking some risk off the table in your portfolio may in fact be the right answer.

On the other hand, if your portfolio plan is very tight - that is, you've run the numbers and there's a good chance you'll run out of money unless you manage to grow your balance significantly between now and retirement - that's a good reason to short-shrift peace-of-mind considerations in favour of making sure your money bounces back when the market eventually recovers. Given the low return potential of bonds and cash, you can't afford to shift into them unless you're also willing to delay retirement and/or dramatically reduce in-retirement spending.

Can you Mentally Tolerate Further Falls?

The aforementioned questions all relate to gauging your risk capacity - how much risk do you need to take in order to make your plan work? In general, risk capacity should be the biggest driver of how much room to make for more volatile investments with higher return potential.

But risk tolerance - your ability to mentally handle losses - is also a consideration. If the volatility of your too-aggressive portfolio has been consuming more of your attention than it should or if you're pondering an extreme manoeuvere like retreating entirely to cash, that's a signal that at least a modest derisking beats standing pat. That might include scaling back slightly on equities or maintaining the same equity exposure but scaling back on the riskiest of stock funds and favoring lower-risk funds instead

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.