Balancing Risk and Reward

Choosing the Right Mix for Your Portfolio

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Market participants must weigh the amount of risk they are willing to take in exchange for return or income. What does that mean in today’s environment?

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Why it’s time to talk about risk

This video explains why it’s the right time for investors to consider all the risks to their portfolios. Scroll down to learn more about the types of risks investors face.

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What are the main risks investors face?

When you think of investment risk, you likely think of asset-price volatility: the variability of an asset’s return relative to its average return. That is a leading risk investors face, but there are others that can have a significant impact on your investments. Here are seven additional risks investors should know about — as well as tips for how to reduce those risks.

Click each box for more information

    Help reduce the risk

    Consider short- or medium-term bonds or bond ladders that may help maintain earning potential.

    Help reduce the risk

    It may be advisable to hold asset classes that respond favorably to unexpected inflation, such as Treasury Inflation-Protected Securities (TIPS) and real assets such as commodities and real estate. Over time, equities, too, tend to rise during periods of inflation.

    Help reduce the risk

    Institute a plan to systematically reduce a concentrated holding, along with regular portfolio rebalancing.

    Help reduce the risk

    Allocate an appropriate amount of cash alternatives and other liquid assets to your portfolio to help sell investments quickly should the need arise.

    Help reduce the risk

    Limiting exposure to lower-quality bonds can help.

    Help reduce the risk

    Diversification, both internationally and domestically, and hedging can help.

    Help reduce the risk

    Diversify portfolios by country and region.

Greater risk may not lead to greater reward

Taking on more risk does not necessarily result in greater returns over every time period and for every asset class. This is the difference between compensated and uncompensated risk. To help explain, take a look at the performance of U.S. large-cap equities relative to U.S. bonds for two distinct time periods, below.

Benefiting from the risk premium

As shown at right, from 1997 through 2017, the average amount of risk premium — or compensation for risk — that large-cap stocks generated above bonds was 3.2% per year, while the volatility (or standard deviation) was 11.6% higher for equities than for bonds. The 3.2% risk premium was investors’ reward for their willingness to take on the additional volatility risk associated with equities.

Sources: Morningstar and Wells Fargo Investment Institute. Data from January 1, 1997, through December 31, 2017. Compounded annualized rate of return.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market. The S&P 500 Index is generally considered representative of the U.S. stock market.

Index return information is provided for illustrative purposes only. Index returns represent general market results and do not reflect actual portfolio returns; the experience of any investor; or the impact of any fees, expenses, or taxes applicable to an actual investment. Nor do such returns constitute a recommendation to invest in any particular portfolio or strategy. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Both stocks and bonds involve risk, and their returns and risk levels can vary depending on prevailing market conditions. Bond prices fluctuate inversely to changes in interest rates.

When there is no risk premium

January 1, 1998, to December 31, 2007, represents a 10-year period of time when U. S. large-cap equity investors took uncompensated risk. During that period of time, U.S. large-cap equities and bonds returned exactly the same amount: 6.0%. Yet stocks remained more volatile than bonds; there was no equity risk premium.

Sources: Morningstar and Wells Fargo Investment Institute, data from January 1, 1998, to December 31, 2007. Compounded annualized rate of return.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market. The S&P 500 Index is generally considered representative of the U.S. stock market.

Index return information is provided for illustrative purposes only. Index returns represent general market results and do not reflect actual portfolio returns; the experience of any investor; or the impact of any fees, expenses, or taxes applicable to an actual investment. Nor do such returns constitute a recommendation to invest in any particular portfolio or strategy. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Both stocks and bonds involve risk, and their returns and risk levels can vary depending on prevailing market conditions. Bond prices fluctuate inversely to changes in interest rates.

The solution? A diversified portfolio

A portfolio that includes global equities, global fixed income, REITs, commodities, and possibly hedge funds may generate a better risk-adjusted return over a full market cycle and reduce the likelihood of uncompensated risk.

For example, the hypothetical diversified, balanced portfolio here yielded a 227% return vs. the 171% return for the less diversified portfolio over the same time period.

Source: Wells Fargo Investment Institute, as of December 31, 2017

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market. The S&P 500 Index is generally considered representative of the U.S. stock market.

Index return information is provided for illustrative purposes only. Performance results for the moderate growth & income four asset group portfolio (without private capital) and the 60/40 portfolio are hypothetical. Hypothetical results do not represent actual trading. Index returns reflect general market results; do not reflect actual portfolio returns or the experience of any investor; and do not reflect the impact of any fees, expenses, or taxes applicable to an actual investment. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Hypothetical and past performance do not guarantee future results.

See definitions of the indices and risks associated with the representative asset classes.

Diversifying risk for possible reward

Mixing assets together in a portfolio can help mitigate the asset-class-specific risks while capturing many of the potential rewards. The chart below illustrates expected risks and rewards by asset class.

Asset Class Strategic (10-15 Year)
Hypothetical Return		 Hypothetical Strategic
Standard Deviation (Risk)		 WFII Estimated
Risk/Return Tradeoff
U.S. Taxable Investment Grade
Fixed Income		 3.1% 4.5% Neutral
Potential Asset-Class Rewards:
Event risk mitigation		 Potential Asset-Class Risks:
Interest rate risk
Duration risk
Credit risk
High Yield Taxable Fixed Income 6.1% 12.0% Unfavorable
Potential Asset-Class Rewards:
High income		 Potential Asset-Class Risks:
Interest rate risk
Duration risk
Credit risk
Developed Market ex-U.S.
Fixed Income		 2.8% 9.0% Unfavorable
Potential Asset-Class Rewards:
Event risk mitigation
Global diversification		 Potential Asset-Class Risks:
Interest rate risk
Duration risk
Credit risk
Currency risk
Emerging Market Fixed Income 6.8% 12.0% Neutral
Potential Asset-Class Rewards:
Global diversification
High income		 Potential Asset-Class Risks:
Interest rate risk
Duration risk
Credit risk
Currency risk
Geopolitical risk
U.S. Equities 7.7% 16.5% Neutral
Potential Asset-Class Rewards:
Inflation hedge		 Potential Asset-Class Risks:
Volatility risk
Developed Market ex-U.S. Equities 7.5% 17.5% Neutral
Potential Asset-Class Rewards:
Inflation hedge
Global diversification		 Potential Asset-Class Risks:
Volatility risk
Currency risk
Emerging Market Equities 9.0% 24.0% Neutral
Potential Asset-Class Rewards:
Inflation hedge
Global diversification		 Potential Asset-Class Risks:
Volatility risk
Currency risk
Real Estate Investment Trusts 7.2% 18.0% Favorable
Potential Asset-Class Rewards:
High income
Inflation hedge		 Potential Asset-Class Risks:
Volatility risk
Interest rate risk
Real estate market risk
Commodities 4.4% 15.0% Unfavorable
Potential Asset-Class Rewards:
Inflation hedge		 Potential Asset-Class Risks:
Volatility risk
Commodity bear-market
supercycle risk
Hedge Funds 5.1% 5.8%-8.8% Favorable
Potential Asset-Class Rewards:
Absolute return potential
Diversification		 Potential Asset-Class Risks:
Liquidity risk
Leverage risk
Event risk
Transparency risk
Operational risk
Short sales
Derivatives

 

Source: Wells Fargo Investment Institute, as of December 31, 2017. Strategic (10- to 15-year) hypothetical returns are forward-looking estimates from Wells Fargo Investment Institute of how asset classes and combinations of classes may respond during various market environments. Hypothetical returns do not represent the returns that an investor should expect in any particular year. They are not designed to predict actual portfolio performance and may differ greatly from actual performance. They are based on estimates and assumptions that may not occur. Standard deviation is a measure of volatility. It reflects the degree of variability surrounding the outcome of an investment decision; the higher the standard deviation, the greater the risk. Index returns reflect general market results and do not reflect the impact of any fees, expenses, or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance is no guarantee of future results. Different investments offer different levels of potential return and market risk.

See definitions of the indices and risks associated with the representative asset classes.

More Questions, Answered

The full Balancing Risk and Reward report also addresses these questions:

  • What risks are investors facing at this stage in the economic cycle?

  • How do psychology and emotions influence investor behavior
    during market fluctuations?

  • How can investors assess their risk tolerances and set their risk budgets?

  • How can diversification help mitigate risks?

    • View the Full Report

Investment Expertise and Advice to Help Clients Succeed Financially

Wells Fargo Investment Institute is home to more than 100 investment professionals focused on investment strategy, asset allocation, portfolio management, manager reviews, and alternative investments. Its mission is to deliver timely, actionable advice that can help investors achieve their financial goals.

For additional investment insights and timely market commentary, visit our website. For assistance with your investment planning or to discuss the points in this report, please talk to your investment professional.

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