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Vanguard CEO: Time to check your clients' risk speedometers

08 September 2017 | Topical insights

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Commentary by Vanguard Chairman and Chief Executive Officer Bill McNabb.

More than a decade ago, a well-known American investor and commentator published a memo to his clients titled simply "Risk." In it, he distilled the relationship between investors and risk.

"When you boil it all down, it's the investor's job to intelligently bear risk for profit," he wrote.

It's not surprising, then, that everyone from portfolio managers to behavioural economists avidly studies how investors' reactions to risk influence not only their individual investment decisions but also the broader financial markets. I'm a big fan of some of the behavioural finance work being done, which includes studies by Vanguard's own investment strategists and analysts.

A lens on investor behaviour

For example, in January our Investment Strategy Group introduced a "risk speedometers" report to look at how investors are reacting to market developments. This lens on real-world behaviour measures the risk investors are taking in a given period by calculating the difference between net cash flows into higher-risk assets such as equities, and net cash flows into lower-risk assets such as US Treasury securities. The measures are then compared with long-term averages.

In the spring, the risk speedometer spiked. The rise was fueled by investors' decisions to direct more of their money to equity investments in developed and emerging markets and to riskier bond credit categories.

A spiking speedometer seems a fitting analogy for what can happen when one's guard is down. I consider myself a responsible driver. Still, when the motorway is clear and the weather is nice, I might glance down at the speedometer and find that my foot has gotten a little heavy.

The same phenomenon is possible with an investment portfolio. Just as our attention can drift from our speed (and our risk level on the road) investors can neglect the risk level of their portfolios' asset allocations. Experience teaches that investors, particularly those who invest without the aid of professional advisers, are especially prone to lose sight of risk when markets have been buoyant.

How I manage risk in my own portfolio

Rebalancing is one of the best ways I know of to help manage risk. Without rebalancing, a portfolio may end up potentially riskier than intended and no longer aligned with the investor's goals.

I have a ritual I perform every June and again each December, between Christmas and New Year's, as I prepare for a series of annual meetings with the Vanguard crew. I'll set aside some time, review my investment portfolio, and, if necessary, rebalance back to my target asset allocation.

My own portfolio is a mix of equity and fixed income funds, and I invest in both actively managed funds and index funds. Most years, I'll make a minor adjustment to get back to the appropriate asset allocation for my own longer-term goals and risk tolerance. It's not all that complicated, although my portfolio is a little more complex than some because I own more funds than we'd typically suggest. (As chairman, I feel I should own a significant number of Vanguard's funds.)

Consider your clients' options

Investors should consider rebalancing if their target allocation is off by 5 percentage points or more. Admittedly, this is often easier said than done. When an investment has performed exceptionally well, people have a hard time trimming it. They can be led astray by an old (and none-too-helpful) investing maxim: Let your winners run.

Fortunately, in recent years we've seen all sorts of advisers and investors take steps to rebalance. Many of the endowments, foundations and traditional pension plans that Vanguard serves have good processes built into their investment guidelines to make sure rebalancing takes place on a regular basis. And among those in defined-contribution retirement plans, more and more are using target-date funds, in which rebalancing happens automatically.

When you explain rebalancing to your clients, use their target asset allocations as your guidepost. Explain that they shouldn't be afraid to buy into bad news, nor should they worry about the noise of the marketplace. And make sure they understand the importance you place on a rebalancing ritual.

And remember, the goal of rebalancing is to manage risk, not to avoid it altogether. Risk is inherent in investing – we just want to bear that risk intelligently.

That insightful memo on risk I mentioned earlier included a saying often attributed to the American humorist Will Rogers: "You've got to go out on a limb sometimes because that's where the fruit is."

Bill McNabbBill McNabb
Vanguard Chairman and CEO

Important information:

This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

It is designed for use by, and is directed only at, persons resident in the UK.

The material contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

The opinions expressed in this article are those of individual author and may not be representative of Vanguard Asset Management, Limited.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

VAM-2017-08-23-5095

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