When to Increase the Risk of Your Portfolio

Timing the market is a risky business, but are there some simple signs of opportune points to enter the market for long-term investors?

Fernando Luque 3 June, 2011 | 11:26AM
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For the long term investor, knowing how to increase or decrease the risk of his or her portfolio is a relatively easy task. If one wants to increase the level of risk one can simply increase the duration of the portfolio’s bond funds, switch assets from the fixed income portion of the portfolio to the equity portion, or overweight emerging markets equity funds. That is the easy part of the game. Knowing when to increase or decrease the risky assets in a portfolio is a more complex task.

At the risk of sounding redundant, the level of risk is generally determined by the investor’s risk aversion and, to a certain extent, by the age of the investor. We tend to consider, for example, that young people can take on more risk than old people, which in some way is a correct approach. The younger the investor, the more time he or she will have to recover from the potential drawdowns in his or her portfolio. Or, in other words, the longer the time period, the greater the probability the investment will end with a positive return. The problem with this approach is that ex-post we can find some periods where the investor (young or old) would have not obtained a satisfactory return for his or her investment. Let’s think for example of an investor who would have put all his/her money in the stock market at the beginning of 1965. They would have had a terrible return even after 15 years of investment (less than 2% per year in USD considering an investment in the S&P 500).

That being said, we have to recognise that diversifying the portfolio according to the age of the investor (allocating, for example, a percentage in fixed income equal to the age of the investor, a measure suggested by Vanguard founder Jack Bogle) is a relatively easy way to get reasonable returns over the long term. Intrinsically, using this system is also admitting that the asset allocation does not or should not depend on the market or macroeconomic conditions. But we also have to admit that if we look back at the market’s historical returns there are some points at which it was more attractive to invest in equities or points that were less risky to invest in stocks. The question is, how to identify those points? And the answer would be, by looking at valuations. This should not be a surprise. Several studies have demonstrated that the level of valuation at the point at which one invests determines in great part the long term return that one will obtain.

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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

Fernando Luque

Fernando Luque  is Senior Financial Editor at Morningstar Spain