Morningstar X-Ray: A Clearer View of Risk

Perhaps the hardest investing concept to wrap one's brain around is risk. For many people, it certainly meant something different a few years ago than it does today. When the bull market was raging in the late 1990s, risk was shorthand for missed opportunity. Risk meant not owning that hot stock or fund and foregoing those champagne dreams and caviar wishes.

Today, obviously, things are different. Most investors have been rudely reacquainted with the true meaning of risk in second half of 2007: losing money when things don't go as expected and failing to meet your investment goals. The statistical manifestation of risk is volatility, typically measured by an investment’s standard deviation. But in managing one's own investments, it's important to rise above the stats and ask this simple question: How could things go wrong here? In other words, how might you fail to meet your investment objectives?

Thinking about risk in the abstract and actually managing it are two different exercises. Fortunately, investors do have tools to identify what bets they’re taking, and that knowledge can lead to constructive changes to their portfolios. At the very least, knowing what risks are embedded in your portfolio helps you manage your own personal expectations so that when things go wrong, you’re not surprised. Losing money sure doesn’t feel good, but it feels even worse when you’ve been blindsided.

Time to X-Ray Your Portfolio
Our Portfolio X-Ray tool can help make sure you know where your risk exposures are. The idea is straightforward but powerful: Rather than looking at the risk-return profile of each fund you own, aggregate all of your investments into one portfolio and let Morningstar help you identify how things might go wrong. (Note: Morningstar.co.uk's Portfolio X-Ray tool is for Registered Members. If you're not a Registered Member, you can register here for free). If you don't want to register or just don't want to go through the hassle of setting up a full portfolio, you can also use our Instant X-Ray tool. However, Instant-X-Ray does not enable you to save your selected holdings for review on future visits to the website. Type in your holdings and allocations there and hit the “Show X-Ray” button.

Getting started is easy enough. The first necessary step is entering each security you own into Portfolio Manager. Click on the "New Portfolio" icon, give your portfolio a name, and choose between a Watchlist Portfolio and Transaction Portfolio. A Watchlist Portfolio is easier to maintain, but cannot record transactions--if you just want to enter your current portfolio allocations without any follow on transactions, this is the tool for you. A Transaction Portfolio requires a bit more effort to set up, but will allow you to accurately track your portfolio's performance and exposures over time. In any case, hit next and on the next screen type in the name of your investment. You'll also need to indicate your allocation to each fund. That will make your portfolio accurate in terms of position sizes and market value. To keep it accurate, update your holdings when you make new investments or reallocations.

Now you're all set to analyse your risks. Click on the "X-Ray" icon on the top right of the Portfolio Manager page. On this next screen, there's a ton of useful information. The idea here isn't to give advice on all imaginable combinations of assets; rather, we’ll simply offer a guide to some things to look for when you're ready to evaluate the often-invisible risks in your portfolio.

Asset Risk. This is a biggie. Asset risk is a function of how your portfolio is divided across shares, fixed-interest, direct property, and cash. There are safer and riskier corners of the stock market, but generally equities carry more risk than bonds, and bonds carry more risk than cash. The flip side, of course, is that more risk typically generates higher returns over long stretches of time. That's why over most multi-year periods, shares have outpaced bonds, which have outpaced cash. On the cash issue, note that your portfolio's percentage of cash is different than the amount of cash you hold. That's because most of your funds carry some of amount of cash (or cash equivalents--Morningstar classifies all bonds with maturities of less than one year as cash). That's important to know because it might mean you have more of a cushion in a down market than you realise.

Style Risk. In your equity holdings, are you making a large bet on growth stocks? Do you have sufficient small-cap exposure to take advantage of rallies in that market? Does your portfolio have sufficient balance to benefit from both growth and value rallies? Check out the "Investment Style" section of the X-Ray tool to answer these questions. There you'll quickly see what corners of the market you're betting on. A really nice feature here is that the X-Ray goes beyond a fund's official category (e.g., mid-value, small-growth) and takes one aggregated snapshot of all the stocks you own within mutual fund portfolios. So if your mid-value fund happens to currently own a bunch of large caps, the X-Ray will capture it. Also check out the "Stock Stats" section of the page. There you'll get some more advanced statistics about the stocks you own.

Stock Risk. How many eggs do you have in one (stock) basket? You may well own funds that have holdings in the same underlying company or companies. X-Ray will aggregate them for you so you can see your total exposure. At the bottom of the page, check out the section entitled "Top 10 Underlying Holdings".

Sector Risk. The now-classic example of sector risk is the abundance of technology stocks many investors owned in 1999 and 2000. Some of that risk-taking was deliberate: Investors piled billions of pounds into tech-only funds or aggressive-growth funds where the large majority of assets were devoted to tech, telecom, biotech, and media stocks. But many investors unwittingly took on tech-sector risk. Aware of their risks or not, most investors subsequently got burned. A more recent example is given by the financial sector meltdown in the second half of 2007. A quick glance at the "Stock Sector" portion of the X-Ray page will let you know where your bets are now. If you're uncomfortable with how much--or how little--of a particular sector you own, it might be time for action.

Country Risk. How much exposure to foreign markets do you have? How much do you want and which regions and countries do you prefer to invest in? The “World Regions” section is pretty self-explanatory. Most UK investors tend to have a large majority of their investments here at home, but when foreign markets make up lost ground, UK investors with no foreign exposure will lose out. One thing to take note of here is one's emerging markets exposure within the three regions specified.

More Detail. If you want to know exactly where your bets are coming from, you can click the “Holding Details” button in any section of the Morningstar X-Ray. Doing so will show you the exposure of each underlying fund in a format that makes it easy to compare figures across your individual holdings.

Seeing the Big Picture
Every investment decision--no matter how conservative or aggressive--carries risk. The risks associated with aggressive decisions, such as buying a biotech fund or a fund that invests only in China, are relatively easy to see. But keep in mind the meaning of risk: It's the possibility of not meeting your investment goals. Thus, conservative choices also have risk insofar as they limit or even eliminate one's ability to meet certain investment targets. Investors today who have piled into cash or principal-protection securities have certainly managed to limit their downside exposure, but the question arises as to whether they've increased the risk in their portfolio by seriously curtailing their upside potential and ability to meet whatever goals they might have. With the X-Ray tool at hand, answering that question becomes a whole lot easier.