Big market moves always give investors a bit of portfolio vertigo. Are you too close to the edge in terms of risk? Could you get burned again as in 2008?
Few retirement savers do a comprehensive review of their portfolios to see if the sum of the parts creates an unwieldy amount of risk. But by turning to some commonly used gauges in money management circles and asking some crucial questions, you can quantify your portfolio risk — and decide how much will allow you to sleep at night.
An essential question to ponder first is your risk capacity — that is, your ability to sustain a loss of a certain percentage without compromising your future standard of living. Some investors have several portfolios and other assets, so a hit to their stock holdings would not impair their lifestyle over time. Others, however, are more vulnerable.
Your time horizon is a prime consideration. If you have decades before you withdraw retirement funds, you have time to bounce back from a market downturn; those in or near retirement may want to take less risk. And even if you have plenty of time, you may not be able to stomach much volatility.
‘‘What is your investment horizon, and how long do you envision withdrawing funds?’’ asked Hal Ratner, chief investment officer of Morningstar’s European investment advisory service, ‘‘and what is the likelihood that either of those periods might change?’’
One fundamental way of seeing how your retirement kitty would suffer in a downturn is to vet the various risk measures of the funds or stocks in the portfolio.
For example, you can look at how the fund or stock performed during the worst years, focusing on the 2008 collapse. This is pretty simple to look up online with services like Yahoo Finance or Morningstar.
You can also look at an index fund that represents what you hold as a benchmark. For instance, one proxy for large-cap stocks is the SPDR S&P 500 exchange-traded fund, which lost nearly 38 percent in 2008. Could a catastrophic drop like that happen again? It’s possible, but the more important question is, could you afford to lose nearly $4 out of $10 invested? Would you have enough time to recover from such a loss before you retired? Picking the right benchmark is important to see that you’re comparing apples to apples.
Another useful indicator for mutual and exchange-traded funds, found on Morningstar.com, is an upside or downside capture ratio. When a fund rises, the upside capture ratio will tell you what percentage of the market’s gain it’s capturing. A good number is close to 100 percent. On the downside, when the market drops, you want that percentage to be smaller.
Individual stocks with long-term records can also be vetted for downside risk. Prices can be incredibly volatile — particularly for big blue chips — so pay attention to total return, which is the price and the dividend payment. Exxon Mobil, for example, one of the largest US stocks by market capitalization, has had a seesaw price history as the market either favored or backed away from energy stocks. The company’s stock lost 13 percent in 2008 and 12 percent in 2009, but has appreciated over the last three years.
For long-term stockholders, drops can offer opportunities, so downside risk isn’t an absolute measure. If you plan to hold a dividend-paying stock like Exxon Mobil, you can always buy more shares at a lower price when it falls, at no commission if you’re in the dividend-reinvestment plan that most big companies offer. But don’t put most of your money in any single company, including your employer’s. You’ll compound risk in one holding, and there’s no need to do that when you can own mutual or exchange-traded funds that own hundreds of securities.
Once you get an idea of how much a stock or fund can lose during a market crash, you need an idea of past and present volatility, which is measured by standard deviation, a statistic that shows variation from an average. High standard deviations reflect high price volatility and generally greater risk.
Advisers can examine your portfolio and measure standard deviation. Or you can find those numbers online. In any case, flag funds or stocks that have high standard deviations. Do they represent large portions of your portfolio? Do you have a good idea of what might happen to your wealth if they go south?
‘‘The standard way of measuring risk is standard deviation,’’ said Derek Tharp, a financial planner with Mote Wealth Management in Cedar Rapids, Iowa. When working with advisers, he cautioned investors to ‘‘look at what you want to accomplish — how do you want to get you there?’’
Doing a risk budget, that is, a written statement of how much risk you’re willing to take, is part of the portfolio-planning process. You can always go for higher returns, but this always means accepting more risk. Your risk budget should be part of what money managers call an ‘‘investment policy statement.’’ This is a set of written objectives for risk, return, and long-term goals. Are you focused mainly on income, appreciation, or a combination? These are essential details for your statement.
Experienced planners, Tharp suggested, can run analyses to see if your portfolio will realize your goals. A planner should be able to give you the probability of having enough to retire comfortably with your asset mix.
What if you or your adviser discover that you’re taking on too much risk? Simple adjustments can be made to reallocate to less risky assets, like bonds. While the value of stocks can evaporate in a bad downturn, bonds deliver an interest stream and the principal invested, regardless of what the market is doing.
But that doesn’t mean you can’t lose money in bonds. The worst year in the last 20 years for intermediate-term bonds was 1994, when they lost 5 percent in total return, according to Ibbotson Associates (though you don’t lose money in government bonds if you hold to maturity). The next-worst year was a 2 percent loss in 2009. So ratcheting up your bond holdings is generally good for capital preservation.
Just keep an eye on credit risk, diversification, and inflation. You can still lose money in bonds if the issuer defaults, or you could miss out on a better opportunity if interest rates rise. You are most vulnerable in bond mutual funds or if you trade them.
Ultimately, creating a prudent portfolio means having a conversation. Talk about it with your advisers, spouse, or partner at least once a year.
What you can expect in any given year is a subject that Cathy Pareto, a financial planner in Coral Gables, Fla., says she discusses with clients: ‘‘Plot out a chart. What’s a realistic range of returns in actual dollar amounts? When markets are doing well, everyone wants to take on more risk. But what is your specific objective?’’
When you sift through all of your portfolio vulnerabilities, you need to ask two key questions: What’s the worst case for what I own, and would a loss based on that dire case hurt my lifestyle in the future?
If you’re a long-term investor or won’t need your nest egg for decades, you have some flexibility. If not, you need to make some changes to reduce risk. If you see the amount of risk you have will imperil your future lifestyle, now’s the time to take action: Don’t wait for the market to tank to spur you to action.