Making Your Portfolio Less Risky

After its stunning gains in the last three quarters of 2009, the stock market has hit a rocky patch. Amid a series of gut-wrenching plunges, it’s natural to think about moving money to the sidelines.

Although standard investment advice calls for leaving your stock-market allocation alone through thick and thin, some simple arithmetic shows that a modest move from stocks to cash won’t torpedo a long-term plan. If it helps you sleep at night ... well, that’s nothing to sneer at.

Consider an investor with 50% of her portfolio in stocks, 40% in bonds and 10% cash. Assume she’s betting on long-term returns averaging 10% on stocks, 5% on bonds and 3% on cash.

After 12 months, every $100 in this portfolio would grow to $107.30, for a 7.3% gain. That’s in line with what many financial advisers would project for a diversified portfolio.

Now suppose the investor thought the stock market had become too risky and reduced the stock holdings to 40%, increasing cash to 20%. Every $100 would grow to $106.60 if returns held to the long-term average. That sacrifice isn’t so bad if it really brings peace of mind.

What if the investor’s fears come true? Let’s assume stocks fall by 20% during the next 12 months. Every $100 in the original portfolio would fall to $92.30, while the more conservative portfolio would fall to $94.60.

Of course, the strategy would reduce returns if stocks took off. If they gained 20%, the original half-stock portfolio would grow to $112.30, the conservative one to $110.60. Still, that’s not a dramatic difference for a single year.