Finding Hidden Risk in Your Portfolio

It depends on how you look at it.

U.S. stocks are expensive by historical standards and the market has been choppy since mid-September. Nervous?

To figure out how much risk you’re exposed to, try looking at your portfolio from five different angles:

1 Allocating Assets

Start with the classic approach: What percentage of your money is in the four major asset classes? We’re talking here about stocks, bonds, cash investments like Treasury bills and savings accounts, and alternative investments such as gold, real estate and hedge funds.

There’s the obvious insight: The more you have in stocks, the riskier your portfolio will be. But alternative investments and bonds can also boost your portfolio’s risk level.

For instance, while a 2% allocation to gold stocks may damp your portfolio’s overall price swings, a large investment could increase your portfolio’s volatility.

Similarly, while bonds are associated with safety, some sectors can be almost as risky as stocks. In 2008, bank-loan funds plunged 29.7%, highyield corporate “junk” bonds dropped 26.4%, high-yield municipal bond funds fell 25.3% and emerging-market debt funds slid 17.6%, according to Chicago investment researchers Morningstar.

2 Riding the Cycle

For an alternative perspective, consider how your portfolio might perform in different economic scenarios— and aim for an investment mix that will fare reasonably well, no matter what happens.

For instance, rapid growth and rising inflation can be good for stocks but rough on bonds, as rising interest rates pummel bond prices. If inflation really picks up, gold typically shines and real estate often holds up well.

But today, with the energy sector pressured by plunging oil prices, the big concern is slower global growth. When recession looms, stocks and low-quality bonds often get hammered, but you might earn offsetting gains with high-quality bonds.

3 Small and Value

Historically, investors have earned superior returns by overweighting smaller-company stocks and so-called value stocks, those shares that appear inexpensive relative to current profits or corporate assets. By contrast, growth stocks—which boast faster increases in sales and earnings—have proved to be disappointing investments, on average.

I suspect that smaller companies and value stocks will continue to outperform over the long haul, though I also suspect the advantage will be more modest, now that the small-cap and value effects have been so well-publicized.

Overweighting small companies and value stocks? This extra return may come with added risk: Smaller-company shares usually suffer more than large stocks in a market down- turn. Meanwhile, value stocks often have shakier finances than growth stocks, so they could generate wretched performance in a bad economic slump.

4 Sooner or Later

You might also view your portfolio in terms of short- and long-term investments. Short-term investments include savings accounts, money-market funds, certificates of deposit and short-term high-quality bonds.

These are all holdings that can be unloaded at short notice with little or no risk of investment loss. Because of that low risk, they’re a good place to stash money you will need to spend in the next five years.

Think of the rest of your portfolio as long-term investments designed to cover costs that are more than five years away. Got money you’ll need to spend soon sitting in longterm investments? You could be courting financial disaster.

5 Core and Explore

No matter how the stock market performs, there’s a danger your results could be substantially worse, depending on the investments you own. With that in mind, some investors follow a core-and-explore strategy. For their portfolio’s core, they use market-tracking index funds, thus locking in the global stock market’s return for part of their money.

These investors then seek to enhance returns with active investment bets. Those bets might include actively managed mutual funds and individual stocks.

The more you have in welldiversified index funds, the greater the likelihood that your results will mirror the broad market. The more you have in active investment bets, the greater the chance for outsize returns. But with that chance comes the danger that your portfolio will lag far behind the market averages.

The more you have in well-diversified index funds, the greater the likelihood that your results will mirror the broad market.