My friends keep posting YouTube videos of crazy risk takers on Facebook. (OK, I do too.) Some of the stunts look like something I might have tried when I was younger. Others are so risky, such as base jumping off anything, that I would never dream of taking such risks. These crazy videos got me thinking about the risks that we are willing to take with respect to our finances.
There are inherent risks in investing. Stocks carry risks in the form of a company’s business activity as well as general movement of the overall market. Bonds carry risk in terms of insolvency and changes in interest rate. The prices of the stocks and bonds on the financial markets are linked to their market risk.
Stocks offer the possibility of the highest returns. They can also quickly go to zero. Thus, they carry the most risk. Bonds, in turn, are less risky than stocks, but riskier than insured savings. Even insured savings have risk, though, in the form of interest rates that do not keep up with inflation.
The fluctuation of prices of stocks and bonds is known as volatility. Stocks are typically much more volatile than bonds. Savings are the least volatile.
Because prices of individual stocks do not behave the same — one may go up while another goes down — owning many stocks, known as diversification, can substantially reduces the degree of risk and volatility for a given level of expected return for an investment.
On the other hand, the effects of the risk of movements in the stock market are mostly the same for the prices of the stocks making up a diversified portfolio. Some stocks may be more affected than others, but it’s not possible to completely eliminate risk for any portfolio containing stocks.
The biggest risk for bonds is the risk that the companies will not be able to pay their creditors. This is known as credit risk. Credit risk ratings of individual bonds are mainly given by three companies: Standard & Poor’s, Moody’s and Fitch. Of course, they were in the news not long ago for helping to blow up the World’s economy by giving unwarranted high ratings to banks and investment firms that were partaking in very risky trades without having much capital to back up their trades.
Anyway, back to bonds. Bonds with ratings of BBB or higher are considered to be investment grade. Any bond rated below this is considered to be high risk or a junk bond. The ratings go from AAA down to C and D, where the bonds are likely in default.
Interest rate risk for bonds has been much in the news. Many people are selling bonds because all the pundits are saying that interest rates will be going up soon (which will decrease bond valuations). This will probably happen at some point, but no one knows when and no one can say how fast interest rates will rise, nor how much they will rise. Because of all these unknowns, plus the fact that bond movements are small relative to stocks, we are not changing our bond holdings.
- For stocks, there are volatility risk and market risk
- For bonds, there are credit risk and interest rate risk
- For cash, bonds, and stocks, there is inflation risk
Your asset allocation (AA) should be set based on how much risk you are willing to accept in your portfolio. Most people reduce their portfolio risk as they age. There is less time when you are older to make up ground if the market has a substantial drop. John Bogle says a good rule of thumb for your AA is to use your age as the percentage of bonds to hold. To stay ahead of inflation, though, you will likely want to level off the change in AA as you get older. This is known as a glidepath AA. To keep a constant AA, you may have to sell some of the assets that have increased and buy the ones that have decreased in value. I check and rebalance our desired AA once a year. To minimize taxes, I try to rebalance using assets in our tax-advantaged funds. Please see Asset Allocation Across Multiple Accounts. I also rebalance throughout the year by placing new funds into the asset that is underfunded.
There are many risk calculators that say they will tell you how much investment risk you are willing to take. I like the Vanguard Investor Questionnaire. Please read the introduction web page before using it. Any of these tools should be used with caution. I would still lean toward John Bogle’s advice of age in bonds over some questionnaire that says I can stand more risk. My wife and I have determined that we do not need more risk than we currently have in our portfolio. Vanguard’s questionnaire recommends an AA of 60/40 stocks/bonds for me.
What would you do if your portfolio actually did lose 50% in another bear market. Be truthful, would you sell stocks? Did you do anything to your asset allocation in 2008? It’s easy in good times to say, “I can handle a lot of risk in my portfolio,” and then bail out of stocks after the market dives. According to a report by Fidelity Investments (PDF) of 7.1 million 401(k) accounts, participants in 401(k) savings plans who dumped stocks from Oct. 1, 2008, to March 31, 2009, when the S&P 500 Index fell 31 percent, and hadn’t returned to equities as of June 30, 2011, had an average account balance increase of 2 percent. Those who maintained their equity allocation during that period saw their balances rise 50 percent on average.
My wife and I are generally invested in “age in bonds” which would be known as a Moderate Risk portfolio. We own the Total US Stock Market (TSM), the Total International Stock Market excluding US (TISM), and the Total Bond Market (TBM). Our AA is 41%/9%/50% TSM/TISM/TBM. We have leveled off our AA and will probably leave it as is for the rest of our lives. This should give us reasonable earnings to stay ahead of inflation, but also a level of risk that we are willing to accept in our golden years.
The final risk to consider is called shortfall risk. It is the risk that your savings will not be enough to last in retirement. According to a Vanguard article titled, “Coping with the risks of retirement investing,” the strategies to combat shortfall risk are
- Save more.
- Consider investments with the potential to keep ahead of inflation.
- Tune out short-term market turbulence.
- Recognize long-term risks.
- Diversify your investments.
- Keep costs low.
- Consider whether an annuity (Single Premium Immediate Annuity or SPIA) is right for you.
Other than the SPIA, these make up the standard strategies to maximize portfolio return while keeping risk tolerable. The Vanguard article gives more detail on each strategy.
Have you chosen an appropriate asset allocation for your age and ability to take risk? How much risk do you need, and how much are you willing to take with your hard-earned money?