The Biggest Risk Factor for Your Portfolio

Is That You, Goldilocks? 
The dictionary defines complacency as "a feeling of being satisfied with how things are without an awareness of some potential danger or defect."

To be sure, it's hard to blame anyone for feeling comfy with the status quo. Economic conditions in the U.S., while perhaps not as strong as would be ideal (especially on the consumer front), can be characterized as decent. Inflation, meanwhile, has been remarkably benign, keeping a lid on interest rates. The stock-market rally that began in the spring of 2009 now rates as the sixth-longest since 1928, and investors expect volatility to continue to be mild, as measured by the VIX index's record-low levels.

That's not to say that unbridled optimism reigns: For many investors, the financial crisis of 2007-2009 hasn't fully receded from the rearview mirror. Plenty of investors, in fact, got themselves in a defensive crouch during that period and never quite got back out of it.

But I am seeing signs of complacency here and there, a tendency to believe that the current stretch of placid economic and market conditions will keep on rolling. I've met retirees who have told me that their portfolios are mostly or even entirely invested in stocks--high-quality dividend payers, but stocks all the same. And to the extent that investors have been buying bonds over the past few years, they've largely been tilting heavily toward the credit-sensitive, higher-yielding types rather than the high-quality bonds that would tend to fare best in an equity-market shock. In short, I'm seeing signs that some investors are casting their lot with business as usual rather than building in defensive hedges in case the economy slows, inflation spikes, or one of many other market-risk factors plays out over the next few years. With stocks looking fairly valued right now, investors' portfolios are apt to be more vulnerable to those kinds of exogenous shocks than they were when prices were lower.

A Delicate Balance 
Of course, it's a mistake to go too far in the other direction, allowing yourself to get spooked out of stocks altogether. There are plenty of dangers out there, but isn't that always the case? There is always something to be worried about. And with current yields as low as they are, the raw materials for strong returns from either cash or high-quality bonds over the next decade are not promising. Investors who get defensive and don't time it just right face a steep opportunity cost.

But it's possible to strike a balance, protecting your portfolio without completely shutting off its return potential. If you want to make sure that complacency hasn't gotten the best of your investment plan, take the following steps:

1) Get back to your true north.
Employing a disciplined asset allocation program, including rebalancing, is the best way to ensure that your portfolio's risk level is in the right ballpark. If you haven't taken a look at your portfolio's asset allocation lately, a good first step is to check out where you stand using Morningstar's X–Ray functionality. Then compare your positioning with that of a set of reasonable benchmarks--a high-quality target-date series, such as those from Vanguard and T. Rowe Price, and/or Morningstar's Lifetime Allocation Indexes.

Investors who have taken a laissez-faire approach to their portfolios are apt to find that the market's ascent has left them heavy on stocks. If that's the case, they'll need to hold their noses and rebalance.

On the flipside, those who determine that they're light on equities will want to proceed deliberately when adding to their positions, given not-cheap market valuations. 

2) Check your sub-allocations. 
Even if your portfolio's baseline asset allocations aren't out of whack, it's worthwhile to check up on your sub-allocations, too, to ensure that your portfolio isn't disproportionately skewing to a certain investment style or outcome. Small- and mid-cap stocks--especially growth-oriented ones--have led the market's ascent over the past five years, so many portfolios may be inadvertently skewing toward them right now. That's true on the foreign-stock side, too. Such stocks will tend to perform well when the economy is on the upswing, which explains their recent outperformance, but they'll suffer more when economic growth hits a speed bump.

In a similar vein, even portfolios with reasonable bond weightings may be listing toward credit-sensitive bond types. Even if you haven't been among the investors adding to high-yield bond and bank-loan funds, your diversified bond fund managers may be adding some of these credit-sensitive bond types for you. The red-hot nontraditional bond category, for example, includes many offerings that are light on duration risk and heavier on credit-quality risk.

3) Check liquid reserves. 
In addition to checking up on your long-term portfolio's positioning, it's also a good time to check your liquid reserves, especially if you're retired. Having near-term living expenses segregated from your long-term portfolio can provide valuable peace of mind in volatile markets, and that idea is the bedrock of the bucket approach to retirement portfolio management. Holding a buffer of liquid reserves is also a good practice if you're an income-centric investor; if your yield shrinks for some reason, as was the case when banks cut their dividends during the financial crisis, having cash on hand will give you time to regroup. Here again, you don't want to go overboard, as there's an opportunity cost to holding too much cash: One to two years' worth is plenty.

4) Guard against overconfidence. 
In addition to seeing whether portfolio adjustments are in order, it's also wise to make sure that complacency--or its sibling, overconfidence--haven't worked their way into your financial plan. With stocks posting double-digit annualized gains over the past five years, it may be tempting to plug overly sanguine return expectations into your retirement plan calculations. In reality, high market returns call for ratcheting future projections down, not up.

Data also indicate that many people retire after the market has ascended, no doubt taking comfort in their plump balances. But that heightens the risk that they'll encounter a sharp market decline early in their retirement years, a bad convergence. Somewhat counterintuitively, you're better off retiring after the market has already dropped, and therefore poised for better days ahead, than you are at a market peak.

In addition to bolstering our confidence in our investment plans, strong market environments also have a tendency to engender overconfidence in ourselves, in our ability to select investments as well as to tolerate volatility. The best way to determine if that confidence is warranted or if more humility is in order is to benchmark your past results. I would suggest comparing your portfolio's return with that of a portfolio of plain-vanilla index funds, or even a good target-date fund geared toward someone in your age band.

And to make sure that your portfolio's amped-up returns aren't goading you to take too many risks, keep your focus on risk capacity and pay less attention to risk tolerance.