Does Your Portfolio Need a Risk Audit?

Key Takeaways

• Do a little bit of checkup on your portfolios’ exposures across the style box.
• Make sure that you are holding adequate emergency funds.
• Investors who are approaching retirement or maybe even in retirement should definitely be doing that equity checkup, looking at where their style box exposures land. You’d want to pay even more attention to the fixed-income portion of the portfolio.
• Investors in or approaching retirement can use the Bucket approach to retirement portfolio allocation.
• Checking up on investment costs can be an indirect way to sniff out risks in your portfolio.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Stocks have gotten off to a pretty strong start this year, but Morningstar’s Christine Benz thinks it’s a good time for investors to check up on the risks that might be lurking in their portfolios. She’s here with me to discuss how to conduct a risk audit. Christine is director of personal finance and retirement planning for Morningstar. She’s also host of The Long View podcast and author of a new book hitting shelves this fall called How to Retire: 20 Lessons for a Happy, Successful and Wealthy Retirement.

Christine, nice to see you.

Christine Benz: Susan, good to see you.

Portfolio Risks for Investors in the Accumulation Phase

Dziubinski: So, you say that the types of risks that investors should be looking at really depend on their life stage. So, let’s start with people who are currently working. They’re in the accumulation phase. They have, let’s say, more than 10 years. They’re more than 10 years away from retirement. What type of risks should they be looking for in their portfolios?

Benz: Well, to start, if they have long-term assets, I think there’s a significant risk that many investors are overleveraged to that large-cap growth square of the style box. So do a little bit of checkup on your portfolio’s exposures across the style box. You could also check up on sector exposures. If you’ve been doing nothing or if you’ve been sticking with just a US total market index fund, well, gosh, you have really significant concentration in those US large-cap growth stocks, which is not to say that they won’t continue to climb. For all I know, they might, but it does suggest that you’d want to make sure that you are diversified across the style box.

A really simple fix, I think, for a lot of investors is just looking at that US versus non-US allocation, because non-US markets do tend to have more exposure to what we think of as value sectors. So that’s a nice way to fix it. If you’re a total US market index person, well, just make sure that you are rebalancing into non-US. So, I would start there in terms of the equity exposures. If you’re a long-term investor, just check out that style box exposure, check US versus non-US.

What Accounts Should Investors in the Accumulation Phase Check Up On?

Dziubinski: Got it. Now, how about outside of, say, your retirement account? Should people be checking up on other things if they’re in that accumulation phase?

Benz: Well, definitely liquid reserves is something to check up on. Whether you’re doing a checkup now or you do one at year-end, just make sure that you are holding adequate emergency reserves. The baseline, very basic baseline would be three to six months’ worth of living expenses. But if you’re someone who is moving into retirement or you’re over 50, I would think about having a larger cushion on an ongoing basis, more like a year’s worth of living expenses. And with yields higher today on cash instruments, the opportunity cost of running with that higher liquid reserve, I think, is less than it was a couple of years ago. But the reason you’d want to hold more is just that more can happen as you move on in your life and then also chances are you are in a higher-earning profession than you were 20 or 30 years ago. You may have more people depending on your income. So, to me, it just suggests that you’d want to hold more in cash reserves.

Portfolio Risks for Investors In or Approaching Retirement

Dziubinski: Now, what about investors who are, say, approaching retirement or maybe even in retirement? What should be at the top of their list when it comes to trying to figure out what the risks might be in their portfolios?

Benz: I think that they should definitely be doing that equity checkup, looking at where their style box exposures land. You’d want to pay even more attention to the fixed-income portion of the portfolio. It’s probably grown, or maybe it hasn’t grown, as the years have gone by. Take a look at that, whether you should potentially add more to fixed-income securities, maybe add a little bit more cash even to your long-term portfolio, and then make sure that you have, within that fixed-income portfolio, securities that we know are good equity shock absorbers. So, you’d want to think about having high-quality bonds, especially Treasury bonds, in that portfolio. Based on the research that Amy Arnott and Karen Zaya and I recently completed on diversification, we really found that those types of securities, AAA rated government bonds, give you a lot of diversification for your equity exposure. So, you just want to check up on the fact that, if you have fixed-income exposure, it’s as high-quality as it can possibly be.

Liquid Reserves for Investors In or Approaching Retirement

Dziubinski: Christine, what about liquid reserves for people who are at this life stage? I assume that this would be an important area to check up on, too, right?

Benz: Definitely. So, as you know, I’m a big enthusiast for the Bucket approach to retirement portfolio allocation, and the basic idea there is that you’re holding one to two years’ worth of portfolio withdrawals in cash instruments. And the virtue of that is to protect you in a year like 2022 when your bonds went down, at the same time your stocks went down. Well, what do you pull from? You can pull from cash in a year like that. I think that, as with the accumulators, the nice thing is that it’s not dead money anymore, that even on an inflation-adjusted basis with today’s cash yields, you still have a positive return from your cash instruments. So, holding something like one to two years’ worth of portfolio withdrawals in liquid reserves I think is a good baseline.

Don’t Forget to Check on Investment Costs

Dziubinski: And then lastly, you say that checking up on investment costs can be an indirect way to sort of sniff out risks in your portfolio. Talk a little bit about that.

Benz: Yeah, this is some research that we’ve done on and off in our manager research team over the past couple of decades where we’ve looked at the correlations with expense ratios and risk. We found that there sometimes is a pretty tight connection. And this is especially so in the fixed-income realm. So, if you have a bond fund with a high expense ratio, well, there’s a good bet that that manager is taking risks, investing in higher-yielding, higher-risk securities, in an effort to outrun that high expense ratio. So, if you’re doing some pruning at the securities level and you’re looking on where to start, I would take a look at some of those higher-cost funds. It’s another reason to potentially prune them from your portfolio.

Dziubinski: Christine, thank you for your time today. It’s always good to talk to you.

Benz: It’s always good to talk to you, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch What Your Asset Mix in Retirement Should Be During Higher Interest Rates for more from Christine Benz.