With oil prices gyrating, politics whipsawing, news breaking daily about the trade war with China, and a persistent drone about the bull market’s advanced age, investors know that risk is a constant companion.
In fact, managing risk is one of those fundamental tasks that investors are lectured about over and over: spread your eggs among many baskets, reallocate when the mix of stocks to bonds drifts off-target, reinvest gains and stick with it for the long term.
But with most investors relying on funds instead of individual stocks and bonds, how do you know how much risk you’re taking?
Lots of online tools can help, but experts say the findings should be taken with a grain of salt.
“Risk assessment tools come in all shapes and sizes but seem to always boil down to the same thing,” says Amit Chopra, managing partner at Forefront Wealth Planning and Asset Management in New York. “For individuals, it tells them if they are conservative, moderate, or aggressive, with multiple combos of those three mixed in, such as moderately aggressive, etc.”
[See: 10 of the Best Stocks to Buy for 2019.]
These tools are meant to solve a common problem: the investor who thinks he or she is following all the rules may in fact be miles off base. Your funds’ holdings change over time, one fund may hold some of the same stocks or bonds as another with a very different-sounding name, funds can wander outside their prescribed stomping grounds or have looser investing guidelines than the investor thinks, and individual stocks and bonds in the fund can become riskier over time, or less so.
One of the big challenges for a modern investor is to know risks posed as various funds interact.
Fortunately, it’s not necessary to tally each fund’s holdings on your own. Various online and software tools can do that for you. They know what each fund said it owned in the latest report to shareholders. With a tool like Morningstar’s Portfolio X-Ray you simply list the number of shares of each fund and get a report on how your portfolio as a whole is allocated. Quicken, the financial software, provides Morningstar’s tool in some of its higher-level software.
These and similar services can also guide the investor toward a suitable asset allocation, then make it easy to see if you’re staying on track.
But experts warn against taking any tool’s findings as gospel. Many asset-allocation programs, for instance, ask the user to complete a questionnaire to build a profile dealing with issues like risk tolerance. But if you say you’d sell everything after a 10 percent decline, the program will likely conclude you are very conservative and recommend a portfolio too safe to get you to your goal, while a good human advisor might say you’re worrying too much and should accept dips as part of the game and stick them out.
Many tools are just plain confusing, Chopra says.
“For portfolios, individuals get inundated with Sharpe ratios, standard deviation, and scatter plots,” he adds. “All of which many people find hard to understand on the portfolio level, and far too simplistic on the individual level.”
Still, he has found a tool he likes, Riskalyze. Unfortunately, it is meant for professionals and its cheapest package is $165 per month.
[See: 10 Reasons Investors Shouldn’t Panic About Stocks.]
Small investors can use free or less expensive tools. Morningstar’s, for instance, asks the investor to provide details on the portfolio such as names of holdings and number of shares. The tool reveals broad breakdowns such as the percentage of the portfolio devoted to big-cap stocks, foreign stocks, bonds and cash, exposure to different parts of the world and various industries, and cyclical holdings versus non-cyclical ones. It analyses bond durations and maturities and fees charged.
Finally, it lists holdings that appear in more than one fund, giving an insight into potentially harmful concentration that the investor may not expect. Big stocks like Apple (ticker: AAPL) and Microsoft Corp. ( MSFT), for instance, can show up in large-cap funds as well as ones that zero in on tech issues.
The tool also reaches broad conclusions about how aggressive and diversified the portfolio is, and the type of investor for which it is suited.
“Morningstar’s X-Ray analysis does a pretty solid job in explaining how well your portfolio is diversified across asset classes, sectors, growth versus value, etc.,” says Carter Henderson, director of institutional investing at Fort Pitt Capital Group in Pittsburgh. “This is important to show because you do not want your portfolio loaded up in just one of those characteristics.”
All this can be useful for the investor looking for hot spots needing attention, but doesn’t always get at all potential problems, Henderson says. The report may show the portfolio is spread among a wide variety of assets, but not reveal whether they move as a herd — a correlation that can be quite dangerous.
“Where I think all these retail tools lack is getting into the math and statistics of the overall portfolio — specifically speaking, the correlation amongst the different securities,” Henderson says.
“Using a statistical spreadsheet, I am able to see the correlation to ensure that my stock picks will not move in lock step of each other. Less correlation is better and if you can build a low correlated portfolio, your portfolio can have success over full market cycles — when one part of the portfolio zigs, the other zags.”
Also, tools like this rely on reports of fund holdings that may be out of date, and they analyze risk according to how various assets have behaved in the past, while the future could be different.
“I generally believe risk tools such as Morningstar’s Instant X-Ray are overly simplistic and rely on how assets correlated in the past to help determine future risk,” says Robert M. Wyrick Jr., managing member and chief investment officer at Post Oak Private Wealth Advisors, in Houston.
He says that in a deep market correction, uncorrelated assets like stocks and bonds can move down together instead of offsetting each other as expected.
“Fortunately for investors, better tools are becoming available to assess portfolio risks,” he says.
[See: 7 Expert Investing Moves to Make in 2019.]
“Tools such as Rixtema and HiddenLevers allow investors to crash test their portfolios based on very specific events in the world,” he says, referring to two other products for professionals. “While a bit more expensive than some of the more mainstream risk tools, they are very likely worth the additional cost.”
Inexpensive tools can give small investors useful insight into how well their portfolios are diversified, but for state-of-the-art analysis most will have to consult an advisor or money manager.
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How Investors Can Check for Risk originally appeared on usnews.com
