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Portfolio Risk Levers

People often ask what I think about one proposed asset allocation as opposed to another. More often than not, my answer is indifference — I have no reason to think that either proposed allocation is markedly better than the other.

I like to think of a portfolio as having several levers that you can adjust upward or downward in order to increase or decrease the level of risk.

  • There’s the stock-vs-bond lever.
  • There are the bond-related levers for adjusting interest rate risk, credit risk, and inflation risk.
  • And there are the stock-related levers for adjusting small-cap risk, value risk, and emerging market risk.

In my view, it’s OK to position those levers in any number of different ways, so long as you end up with an overall risk level that is appropriate for your personal risk tolerance.

For example, on the bond side of the portfolio, some experts recommend sticking to only very safe bonds such as short-to-intermediate-term Treasuries. Other experts (e.g. John Bogle and Rick Ferri) take a different approach. Not only do they like the corporate bond allocation included in a “total bond” fund, they suggest going further and including additional corporate bonds as well.

Either approach seems perfectly reasonable to me. The point is simply that, if you choose to increase the risk you take with your bonds, it’s important to adjust the risk level downward in some other way (by using a smaller stock allocation, for instance).

On the stock side, one common strategy is to adjust the levers in some way (most often by increasing the weighting of value stocks and small-cap stocks) with the hope of creating a portfolio that is greater than the sum of its parts, because the various pieces have sufficiently low correlation to each other for you to achieve a bit of extra return via rebalancing between them.

I think such an approach is perfectly fine, so long as the portfolio is adjusted in some other way to bring the overall risk level back to where it should be — by switching to less risky bonds or by increasing the bond allocation, for instance. (I would also caution against putting yourself in a position where you’re relying on a “bonus” diversification-driven return. Investment correlations are not entirely stable, so the fact that something has worked as a diversifier in most historical periods does not mean it will necessarily do so when you need it to.)

Which Risks Are Most Problematic for You?

There are some situations, however, in which it makes sense to be concerned not just about overall risk level, but also about exposure to a specific risk. Generally, these situations are the result of non-portfolio factors in your life.

For example, if you’re a retiree who has a government pension instead of Social Security, and that pension is not inflation-adjusted (or there is a cap on the inflation adjustment), then you’re more exposed to inflation risk than other retirees. And as a retiree in general, you’re more exposed to inflation risk than working investors. As such, you have a good reason to keep the inflation risk in your portfolio low (by using TIPS and I Bonds) and use your other levers to achieve your desired level of overall risk.

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