Is Your Allocation a Good Fit for Your Risk Tolerance?

Over the last few days, I’ve gotten several questions from readers about:

• The loss that Vanguard’s TIPS fund has experienced so far this year, and
• The losses that stocks have experienced so far this month.

For reference, as of this writing, Vanguard’s Inflation-Protected Securities Fund has incurred a year-to-date loss of 8.67%. And, according to Morningstar, Vanguard’s Total Stock Market Index Fund has incurred a loss of 4.53% over the last month, and Vanguard’s Total International Stock Index Fund has incurred a loss of 9.42% over the last month.

Intermediate-Term TIPS and Short-Term Losses

The idea of the intermediate-term TIPS fund is that, over the long term, it should roughly keep pace with inflation. The fund is not intended to protect against short-term losses. And with an average duration of 8.5 years, there’s no way to avoid experiencing several short-term losses over an extended holding period.

As a reminder, when interest rates move, a bond’s price will move (in the opposite direction) by an amount roughly equal to its duration, multiplied by the change in interest rates for similar bonds. Given the 8.5-year average duration for Vanguard’s Inflation-Protected Securities Fund, interest rates on intermediate-term TIPS barely have to move by 1% for the fund to experience the kind of loss it has experienced this year. In other words, this is no big deal.

Or, stated differently, if an 8.67% loss over a few months is a big deal for you, then perhaps this fund is not a good fit for your risk tolerance. For example, you may want to instead consider Vanguard’s new Short-Term Inflation-Protected Securities Fund, which has an average duration of just 2.5 years.

Another thing to remember is that, except in the case of a default, the price of any given bond will move toward its par value as the bond approaches maturity (because its value will, naturally, be its par value when the bond reaches maturity). So if you plan to hold a bond fund for a long enough period of time (longer than the fund’s average duration, as it turns out), an increase in rates is not a problem. In fact, it works out to your advantage, because the new bonds that the fund buys will have higher yields.

Stocks Go Down Sometimes.

With regard to the losses incurred by domestic and international stocks this month, the “this is no big deal” message is even stronger. A loss of less than 10% (and less than 5% for domestic stocks!) is the sort of thing you need to be very comfortable with if you’re going to have money in stocks.

Quite in fact, you need to be OK with the idea of a loss that is a) five-times the size that we’ve seen over the last month and b) coupled with truly terrible headlines of some sort (e.g., the  U.S. going to war with somebody). Of course, you don’t have to relish the idea of a 50% market decline. But you need to know that it could happen. And you need a financial plan that won’t be ruined if it does happen.

If you’re an investor who is new to the stock market and this is your first time experiencing anything other than the superstar returns that stocks have had over the last few years, there are two reasonable ways to respond to this recent decline:

1. You could come to terms with the fact that this sort of thing is normal, and carry on with your plan, or
2. You could decide that your chosen allocation is too risky for your actual risk tolerance, scale back your stock allocation, and count it as a relatively inexpensive lesson (less expensive, that is, than waiting until a full-scale bear market to learn the lesson).

Observing how you feel in the face of real-life losses is the best way to assess your risk tolerance. If a risk tolerance questionnaire told you that you have a high risk tolerance, yet you find that you’re very worried when actual losses come along, the questionnaire was probably wrong.