For investors, there are two key metrics, risk and return. Return is the reward for investing. Investment returns are what fuel the attainment of financial goals such as retirement and funding your children’s education.
Managing your portfolio’s investment risks is a key factor in achieving the types of long-term returns you are seeking.
There are a number of definitions of risk. In general investment risk is the risk that the returns from your investments will differ from their expected returns. Most investors, however, define risk as the risk that their investments will decline in value.
In our experience, the risk of a significant loss on their investments is how investors typically define risk.
In building and managing portfolios for our clients, the balance between potential downside risk and potential rewards are the main driver. Factors such as the investor’s time horizon for needing the money and their personal risk tolerance need to be considered in determining how much potential risk is appropriate for their portfolio.
Beyond the risk of loss, there is the risk of the investor falling short of their goals by not taking enough risk. For example, an investor entering retirement needs to balance out the potential for downside risk with the need to invest aggressively enough to stay ahead of inflation and to help ensure they don’t run out of money in retirement.
Diversification is the investment version of the old adage, don’t put all of your eggs in one basket. A well-diversified portfolio contains some holdings that are not highly correlated to the rest of the portfolio. By not highly correlated we mean that some investments will behave differently from each other under the same set of market or economic circumstances.
For example, a popular large cap stock ETF and an ETF that tracks the total bond market have a correlation of -0.05 to each other over the past decade. The low, negative correlation means that these two ETFs will often behave quite differently in many market environments. Building a diversified portfolio that consists of some holdings with low and/or negative correlations can help in managing the portfolio’s overall risk.
A key tool in implementing portfolio diversification and managing investment risk is asset allocation.
Asset allocation is the distribution of the investments in an investor’s portfolio among various asset classes such as stocks, bonds, and cash. A client’s asset allocation generally goes to another level to include sub-asset classes such as large-cap stocks, small caps, foreign, and so on. There might be several types of bonds such as short-term, corporates, and others.
The exact asset allocation will depend upon the client’s unique situation in terms of their investment time horizon and their tolerance for risk.
In some cases investors may find themselves with a concentrated position in one or more individual stocks. This might arise from an inheritance, from stock-based compensation from their employer or from a position that has been held for a period of time where the stock has experienced unprecedented growth.
In any event, a concentrated position in one of just a few stocks can increase investment risk. If a concentrated position experiences a significant drop in price this can have an outsized impact on the investor’s portfolio.
If the concentrated position is in the stock of an investor’s employer and the company experiences financial difficulties, this could create a double risk. Not only might the stock decline in value, but the investor’s job might also be in jeopardy.
We try to work with clients to deal with concentrated stock positions in the best way possible for their situation, including the potential for using some of the shares for charitable contributions if desired.
While it is not a perfect solution, periodic portfolio rebalancing is critical to maintaining an investor’s asset allocation. Rebalancing means “resetting” the investor’s portfolio back to their target asset allocation. It's typical to set parameters that are acceptable and where no action is taken if the allocation is within those parameters. A common example might be +/- 5% of the target allocation for a given asset class.
The performance of different portfolio holdings relative to one another can cause a portfolio’s asset allocation to deviate from the target asset allocation. Using a simple two security portfolio as an example, an investor’s target allocation might look like this:
After a significant rally in stocks, their allocation might look like this:
At this level for stocks, the investor is taking on too much risk in the event that the stock market corrects.
Under a scenario where we’ve experienced a significant stock market decline, the investor’s portfolio might look like this:
In this case, the reduced level of stocks means that the investor is likely taking too little risk and may not be able to generate sufficient gains to meet their financial objectives.
Rebalancing is commonly done by selling positions in asset classes that are above the rebalancing threshold and reallocating the proceeds to holdings in asset classes that are below their thresholds.
Rebalancing can also be accomplished by taking any new funds added to the portfolio and directing this money to asset classes that need to be shored up.
When rebalancing it's important to take a full portfolio view to include taxable accounts as well as retirement accounts. The overall portfolio allocation is key to controlling overall investment risk. Tactics such as tax-loss harvesting are used with taxable accounts where applicable to minimize the tax impact of rebalancing when it makes sense.
Our investment team at CFM believes that a review for potential rebalancing should be conducted at regular intervals such as every three months.
We feel the best tool to mitigate investment risk is the regular review of our client’s portfolios. This review combines a review of the portfolio’s asset allocation versus the target as well as a review of the portfolio’s holdings.
Are these securities still performing in line with our expectations in terms of relative risk and return compared to other securities in their peer group?
Moreover, we review the portfolio in light of the client’s current financial situation to ensure that their investments are properly positioned in terms of the balance between potential returns and potential downside risk.
Bill Canty, CFP®, CPA
Maureen Walsh, EA, Investment Advisor Rep.
Tina Alteri, CPA, Tax Advisor
Ed Canty, CFP®
Joe Canty, Investment Advisor Rep.