Time To Adjust – Risk In Your Portfolio Allocation

 In Financial Planning

Since this column is about financial planning, I usually try to keep discussions about investments out of it as much as possible.  Remember, our main thesis is that good financial planning leads to easier and better investment management.  We try to be convincing in that all persons should do some financial planning before investing.  If you understand the goals behind your effort to save and the time frames associated with the future use of those savings, better investment decisions can be made.   The plan information may then be used in conjunction with the risk information developed, as discussed in a previous article, to produce a portfolio allocation suitable to your goals and risk profile.  So presumably, prior to now, you built a well thought out portfolio and/or began investing.  The purpose of this article is to encourage you to revisit that original asset allocation decision.

Our premise is that in previously setting out a specific portfolio allocation, you were choosing the expected risk level attached to such a portfolio allocation as well.  At that time you accepted the embedded level of risk.  Your choice to accept some risk proved wise, since risk free returns are extremely low and less than inflation.   Well, today we wish to provide a reminder.  Given the passage of time and the market conditions in equities and bonds, the risk inherent in your portfolio is almost certainly higher today than when you began, whenever that was.  You have been likely subject to risk creep, particularly if your investments include US equities.

We are now nine and one half years since the low in the equity markets in March 2009.  The US indexes have grown basically 4 fold.  300% is a pretty good return over less than 10 years, so you have been very well rewarded for taking risk.  However, as stellar returns have been achieved, the underlying risk of holding the assets producing them has risen. We define risk as both: volatility, given that individuals react poorly to seeing their wealth decimated; and also as below average returns, that make achieving their goals challenging. Valuations have been increasing and with good returns investors have been attracted to holding more and more investments. This sets us up to an environment where both increased volatility and disappointing returns are more probable, hence more risk is imbedded in being invested.

The above represents a challenge even for the most disciplined of investors that have religiously rebalanced their asset allocation.  If you previously accepted the risk associated with having, say 20% of your portfolio in US equity, you should consider that today that 20% allocation would be riskier than in the past.  If you are just considering the percentage allocated and through rebalancing you have kept your position at 20%, your perception will probably be that you have no additional risk.  But if you accept that the allocation originally chosen or approved by you was intended to provide a specific desired risk level, any succeeding risk increase in an item would require you to reduce the dollars or percentage allocated to that item in order to maintain your risk target.  In other words, through rebalancing or new investments we should be maintaining the level of risk desired not the asset allocation originally set.  This is not easy but necessary.

Stand back and consider what level of risk you were trying to achieve when you chose or approved the portfolio allocation you did previously.  See if you can describe it to yourself.  Try to articulate your expectations for that original portfolio in terms of risk.  Then consider what the current desired risk is.  It may have moved up or down based on changes to your planning but even if you believe it to have remained the same, you should consider afresh the allocation that you would choose today given that the risk of each item may have changed.

It is past time to review your portfolio and revisit your personal circumstances, goals and plan. Profits increase our willingness to take risk and discount our angst when the risk does materialize.  Reconsider your allocation now not after it disappoints.  Any asset in the basket that is riskier now should be reduced in the new allocation.  Any asset class that is less riskier today could be increased in the newly designed portfolio.

Don’t let a long stretched bull run shift your allocation into dangerous territory and cloud your perception on the risk you’re actually taking.

Concerned about terms such as “financial planner” or “financial advisor”? Don’t be! Learn why you should be asking whether someone is a Fiduciary.

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