3 Portfolio Risks You May Be Overestimating

In their efforts to avoid certain risk factors, investors may be inadvertently exacerbating others

Christine Benz 15 August, 2014 | 10:31
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With stocks near record-high levels, savvy investors are paying at least as much attention to reducing risk in their portfolios as they are to wringing out more return. And risks seem to lurk everywhere you look--to the potential for rising bond yields to not-cheap equity valuations to political unrest throughout the globe.

Yet, even as it's worthwhile to anticipate and mitigate the effects of those risk factors, there are some risks that investors could be blowing out of proportion, or inadvertently taking other types of risk as they look to offset them. Here are a few of the key ones.

Overrated Risk Factor 1: Invading Principal 

Many retired investors aim to live off whatever income their portfolios kick off, while leaving their principal alone. By subsisting only on yield, they'll never risk outliving their money, and they're apt to be able to leave a nice sum of money to their loved ones.

There's nothing wrong with anchoring a portfolio in income-producing securities, both dividend-paying stocks and bonds. Dividends are an indication of a company's financial wherewithal and have been a huge component of the equity market's return over time. Bond income represents the majority of the return that fixed-income fundholders receive, too.

Yet, the current interest-rate climate makes it challenging for many retirees to live on yield alone. Most high-quality, intermediate-term bond funds yield less than 3% today, and even low-cost, well-managed dividend-focused funds barely pay out more than 2.5%. That may be a liveable yield for those who have a lot of wealth. But for investors who need a higher yield than 2.5% to 3%, the choice is to edge out on the risk spectrum to generate a higher yield or to tap capital to make up the shortfall. I'd argue that periodically tapping capital from appreciated assets--right now, that means stocks and lower-quality bond types--is preferable to venturing into higher-yield/higher-risk investments. Such rebalancing can help reduce a portfolio's volatility. By contrast, investors gunning for income alone are likely to find slim pickings at this time.

Overrated Risk Factor 2: Losses in Core-Type Bond Funds 

Investors are wise to not be complacent about the bond market. Even as declining bond yields--combined with fairly mild inflation--have made bonds a pretty tranquil investment over the past three decades, a reversal of those trends could spell losses for bond portfolios.

But it's also a mistake to overestimate the impact of rising rates for the core-type bond funds that populate most investors' portfolios. For one thing, investors (myself included) have been sounding alarm bells about the risks that rising interest rates pose for bond portfolios for a good three years now. But while interest rates did indeed bump up in the US last summer, jostling bond funds in the process, US yields have declined again so far this year and are lower today than they were three years ago. Therefore those US investors who retreated to cash rather than risk rising-rate-related losses in bond funds have incurred an opportunity cost. This should be a lesson to those for whom rates haven’t yet risen off their record lows.

And even if yields do increase (and bond prices decline), those losses wouldn't compare to the types of losses that equities can incur in periods of volatility. After all, it's a rare core-type bond fund that's taking substantial duration risk at this juncture; the median duration [a measurement of interest-rate sensitivity] for intermediate-term bonds in Morningstar's database is five years, while the median yield is 1.7% currently. That would translate into a roughly 3% loss for the typical intermediate-term fund if interest rates were to increase by one percentage point in a one-year period. That's a fairly big rate hike. Of course, most investors would rather not have to contend with any losses in the safe portion of their portfolios, but that's still a much smaller loss than equities would experience in a period of volatility.

Overrated Risk Factor 3: International Stock Volatility 

Many investors assume that investing overseas will bring greater risk to their portfolios. And it's true that international equity funds are typically more volatile than UK-focused counterparts. More specialised international-fund types, such as diversified emerging markets offerings, are more volatile than UK-focused funds by an even wider margin. Of course, emerging markets, which show up in plenty of diversified international-equity fund portfolios, tend to be subject to geopolitical risks that increase volatility. Moreover, foreign-currency fluctuations add another element of volatility to international-equity funds that isn't there for UK investors adding money to UK-focused funds. 

Indeed, the wild card of foreign-currency fluctuations is one reason why Morningstar's Lifetime Allocation Indexes call for reducing international-equity weightings as a percentage of investors' total equity allocations as investors get closer to retirement. That said, international-equity funds vary dramatically in their volatility levels. Some lower-risk international-equity funds could reasonably serve as core holdings for risk-averse investors. 

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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