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Morningstar.com's Interactive Classroom

Course 307
Getting More Conservative

Introduction

You hate Rush Limbaugh. Blue suits, too.

Yet maybe your investment portfolio could use a little conservatism. Perhaps you overdosedon a hot sectorand suffered one heck of a hangover when it cooled off. Or maybe your portfolio just doesn't need to be very aggressive for you to meet your goals.

This course will cover how you can determine if you're being too aggressive with your investments, and offer various solutions for how to dull an edgy portfolio--at least a little bit.

Are You Being Too Aggressive?

How aggressive you should be with your investments depends on three things:

  • your investment goal, or how much money you'll need
  • your investment horizon, or how long you plan to invest for the goal
  • your ability to handle volatility

To find out whether your current portfolio is too aggressive for your goals, use an online asset allocation tool.

If you find that you're more than likely to meet your goals given your current portfolio, or you find that your portfolio is far more volatile than you thought, consider ways to make your portfolio more conservative.

Alter Your Asset Mix

You can do plenty of things to damp your volatility. The most significant move: Reducing your stock investments and increasing your position in cash and bonds.

Many financial professionals argue that your blend of cash, stocks, and bonds contributes more to your portfolio's return and volatility than what investment styles you practice, what sectors you have exposure to, and what individual securities you choose.

While we believe all of these factors play important roles in your volatility and return, we agree: Asset allocation is huge. And the less of your portfolio you have in stocks and the more you have in bonds and cash, the more sedate your portfolio's performance will be.

Restrain Your Bond Mix

In addition to altering your asset mix, you can curtail the volatility in specific asset groups, too.

For instance, many portfolios include intermediate-term bonds at their core. To damp the volatility of an intermediate-term-bond portfolio, consider adding a short-term bond fund to your mix.

Because the maturity dates of short-term bonds are nearer than those of intermediate-term bonds, short-term bonds tend to be less volatile. They often yield less, as well. Finally, they usually gain less than intermediate-term bonds when interest rates fall, but lose less when rates rise.

Many online financial Web sites, such as Morningstar.com, offer screening tools that are a good starting point for ideas about conservative bond funds. Additionally, analyst recommendations, or picks, are a great place to begin, too. Morningstar.com Premium Memberscan access Morningstar Fund Analyst Picks. (And nonmembers cansign up for a free trial.)

Subdue Your Stock Mix

Lessen your portfolio's volatility by exploring the following options among U.S. stocks.

Very Large Companies
Some studies suggest that, over very long time periods, smaller-company stocks return more than larger-company stocks. That's because smaller companies are usually growing faster than larger companies, and stock prices (and thereby returns) usually keep pace with growth. The faster the growth, says theory, the higher the return.

But the faster the growth and the smaller the company, the more volatile the stock, too. So if curtailing volatility is your goal, focus the U.S. stock portion of your portfolio on the very largest companies. They may not have the same growth potential as smaller companies, but they don't have the same volatility, either.

If you are looking for a good large-company stock fund, you can find ideas by usingan online Fund Screeneror Stock Screeneror browsing analyst recommendations such as Morningstar.com's Fund Analyst Picks, which are available to Premium Members or those taking a free trial.

Dividend-Paying Stocks
Dividend-paying stocks are often called "buffers." That's because their dividends provide a cushion in a difficult market. Although a company's stock price may fall, it will usually pay its dividend. And that dividend props up total return.

Let's take an example. Acme Cement Company's stock price falls from $100 per share to $95 per share in one year. That's a 5% loss. However, the company pays a $7.00 per-share dividend each year. At the end of the year, shareholders have a $95 share price and a $7 dividend. So they haven't really endured a 5% loss. It's really a gain, thanks to the dividend.

Dividends won't always turn losses into gains. But they can curtail volatility.

You can find potentialinvestment ideas by usingthe Morningstar Screen of High Dividend Yields.

Reasonably Priced Stocks
Companies whose stocks trade at high prices relative to their earnings, their sales, or their cash flows harbor what's called "price risk." In such cases, investors have high expectations about the futures of these companies, and are therefore willing to pay a premium for the stock.

If the earnings, sales, or cash flows of these companies don't live up to expectations, however, their stock prices can plummet.

To avoid such price dives, stick with companies whose stocks are trading at moderate prices relative to their earnings, sales, and/or cash flows.

Find ideas by using the Morningstar Screen of Low-Priced Growth Stocks.

Tone Down Your Foreign Mix

If you've been aggressive with your foreign mix, you've most likely been drawn to mid- and small-company foreign stocks, or emerging-markets stocks. Though both offer the promise of big returns, both are very volatile.

To curtail volatility in your foreign position, focus on large international companies that are domiciled in developed markets. They may not have the same growth potential as smaller companies or emerging-markets stocks, but they don't have the same volatility, either.

Find ideas by using an online fund screener. For example, we setMorningstar.com's Fund Screenerwith the followinginputs:Fund Group = International Stock; Morningstar Category = Foreign Large Blend; Morningstar Star Rating = 4, 5; and Average Market Cap Greater than or equal to $10 billion. You can change the inputs to narrow the search further.

Test Drive Before You Buy

Before deciding that you want to add dividend-paying stocks, developed-markets stocks, or short-term bond funds to your portfolio, find out how these new choices would work with and affect your current mix.

Many online financial Web sites offer tools that can help.

Once you see all of the holdings for your "conservative" portfolio, answer a few questions:

  • Will you still be able to meet your goal with this portfolio?
  • How much less volatile is this portfolio?

You may be surprised by what you find. You may see, for example, that you're becoming too conservative. Or, conversely, that the changes you want to make aren't going to make much of a difference as far as your future returns or future volatility are concerned. Or you may find that you've built a better portfolio for your goal.

Quiz 307
There is only one correct answer to each question.

1 How conservative you should be with your investments depends on what?
a. Your investment goal
b. Your ability to handle volatility
c. Your investment goal, your investment horizon, and your ability to handle volatility
2 What's the most significant move you can make to damp your long-term volatility?
a. Increasing your bond and cash investments and decreasing your position in stocks
b. Increasing your position in large-company stocks
c. Buying developed-markets stocks
3 Which type of bond is going to be the least volatile?
a. Long-term bond
b. Intermediate-term bond
c. Short-term bond
4 Why should tilting your portfolio toward larger-company stocks and away from smaller-company stocks curtail its volatility?
a. Because all large-company stocks are growth stocks
b. Because larger companies growing at a slower rate should be less volatile than smaller companies growing at a faster rate
c. Tilting your portfolio toward large-company stocks isn't a good strategy for conservative investors
5 To tone down your foreign investments, consider:
a. Large companies domiciled in developed markets
b. Companies domiciled in emerging markets
c. Smaller companies
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