Mitigating Risk

As mentioned a couple of weeks back the best way of spreading risk within a stock portfolio is to buy an index fund, which will likely contain several hundred stocks and track an index such as the S&P 500.

However you will still have an all-stock portfolio, which is very risky. So how do you reduce that risk even further?

The best way is to add into your overall portfolio a mix of bonds and low risk treasury backed investments. Just like stocks you can buy indexed bond funds too, so it is worth purchasing some of these to smooth out your portfolio.

The next question of course is just how much of each type do you want? At this point it really becomes a decision you have to take – how risk-averse are you?. In your 20s you might be comfortable with a 90:10 stock:bond mix, but if you are more risk averse you might prefer 70:30 or another mix. As you get older though and the time until retirement is closer you probably want to reduce the risk. This hopefully will eliminate the chance of wiping out 50% of your portfolio if the market takes a downtown right as you retire.

So you are now in a situation where you have a stock fund and a bond fund and every few years you are taking money from the stock fund and moving it into the bond fund.

However for the smart investor who wants to just leave their money alone even this is probably too much work. This is where a target date fund comes in.

Take a look at this fund from Vanguard. This is called the Vanguard Target Retirement 2040 (VFORX). This fund is designed for people who will retire or approach retirement in 2040.

Its current make up is

  • 52% US stocks
  • 35% International stocks
  • 9% US bonds
  • 4% International bonds

So it is currently 87:13 stock to bond ratio. So this fund would stop us having to worry about problem number one above as it has both stocks and bonds. But the beauty of these types of fund is they rebalance every few years so that over time they become less and less risky until eventually they become an “income” fund after the target date, designed with minimum risk.

Most investment companies will have similar products, the ones at Vanguard run from “income” for those already retired to a target date of 2065. At present the make up of each of these is as follows.

  Stocks Bonds Short Term
Income 55% 28% 17%
2015 58% 31% 11%
2020 56% 41% 3%
2025 64% 36%  
2030 72% 28%  
2035 79% 21%  
2040 87% 13%  
2045 90% 10%  
2050 90% 10%  
2055 90% 10%  
2060 90% 10%  
2065 90% 10%

As you can see Vanguard’s philosophy is to have a 90:10 mix of stocks and bonds until about 20 years until retirement and then slowly to about 55% in stocks, and the rest in bonds and low risk government securities. even if you don’t invest in these types of fund it’s worth looking at this as a decent benchmark of percentage allocation.

Of course if you want to be riskier or more conservative than this you can invest in whichever target date fund you want.

All large investment houses have these, for example Fidelity’s are called “Fidelity Freedom”.

Using these sort of investment vehicles is a great way to invest, and forget about them allowing yourself to be safe in the knowledge that it is being appropriately adjusted for age or circumstance.

 

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8 Responses to Mitigating Risk

  1. PETER WANG says:

    Steve and Tuffy, I just put that 2040 allocation into PortfolioVisualizer.com. It had a -48% drawdown starting in Nov 2007 which lasted 5 years and 1 month. It had a -38% drawdown starting in April 2000 which last 4 years and 9 months. Because of the actions of Central Banks since the Great Financial Crisis in blowing up asset prices, I fully expect a similarly bad outcome within the next handful of years. The risk is there. I just don’t do buy-and hold any longer.

    • Steve Traylen says:

      I think that’s a fair comment, I just don’t think I’ll be able to Time the market appropriately to rebalance too regularly. People have to do what works for them.

  2. PETER WANG says:

    We’re running 25% US stocks, 20% developed international, 5% emerging, 10% cash, 10% gold, and 30% bonds. That one had a drawdown of -27% during the GFC, and it lasted “only” 2.5 years. By using trendfollowing, we should be able to cut that -27% drawdown down to the -15% range. Then, by watching Shiller’s CAPE ratio carefully, we’ll have 85% of our capital left to go all-in near the next market bottom. We basically did this in 2009, looking for a repeat. See: http://www.multpl.com/shiller-pe/

  3. PETER WANG says:

    This is a nice simple, beautiful rule from portfoliovisualizer.com.

    Shiller’s CAPE Ratio (PE10) market valuation based timing model uses shifts the allocation between stocks and bonds as follows:

    PE10 >= 22 – 40% stocks, 60% bonds
    14 <= PE10 < 22 – 60% stocks, 40% bonds
    PE10 < 14 – 80% stocks, 20% bonds

    It works great, in a backtest going back 18 years. Max DD is -15.66%. Over this time period it beats the balanced portfolio.

  4. GYM says:

    Wow that’s an interesting ETF from Vanguard, where it automatically asset allocates for you? (If I read that correctly). They really come up with some great ideas.

  5. The Vanguard Target Retirement is simple and does all the re-balancing for you. I can see the appeal.

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