What are the risks to your portfolio?

While there are a lot of different risks that can affect your investment portfolio, most of the discussion of portfolio risk centers around volatility, the expected short-term price movements both up and down that occur in nearly all investable asset classes. After decades of research, we are fortunate to possess a set of time-tested strategies to mitigate – although certainly not eliminate – the impact of volatility on portfolio performance and ensure favorable results for prudent investors over time.  

While managing volatility is important, focusing too narrowly on it can overshadow other, equally significant risks to your investment portfolio. For portfolio strategies developed by researchers and investors to succeed, funds typically need to remain invested for relatively long periods of time. 

The exact nature of these other risks varies throughout life stages. In many of our previous resources, such as articles on planning in your 60s and our seminar on retirement readiness, we have elucidated many of the external risks facing portfolios during retirement and how to protect against them. Here, we would like to focus on specific risks of this sort that are applicable to working professionals. As an investor passes through their earning years, they contribute to portfolios and invest in growth-oriented allocations, with the aim of allowing funds to remain invested and to compound through to retirement or other goals. A working professional is able to do this because additional household income is available to fund regular expenses without the need to draw on invested funds. In this post, we will look at some of the risks that can disrupt this additional income, perhaps necessitating a reliance on invested assets to fund expenses.  

Is disability the most underappreciated risk to your portfolio?  

Every year, the Social Security Administration (SSA) compiles data on the probability of disability and death for American workers. The SSA has a vested interest in the accuracy of these figures for use in its projections, as it is effectively the largest insurer against these needs in the country, providing disability coverage to 161 million American workers.  

According to the SSA’s most recent study, American workers have between a 23% and a 28% chance of becoming disabled at some point in time during their working career, with the chances rising with age. Data on the duration of disability is more difficult to obtain. However, the figures from the SSA are based on the SSA’s qualifying standards, which include a requirement that the disability has lasted, or is expected to last, for at least 12 months.  

The exact impact of a disability event varies substantially based on individual circumstances. Factors that contribute to the impact of a disability include: 

• Other income sources in the household 

• Dependent-care responsibilities 

• The amount of fixed costs, such as housing 

• Medical expenses incurred along with the disability event 

• Duration of the disability 

Given all these variables, there is no one-size-fits-all rule to determine the impact of a disability. However, it is safe to say that, in most cases, a disruption to household income that lasts for more than a short period is a serious event with significant consequences to even the most prepared. To gain a better understanding of an individual household’s circumstances, planners project what a household’s cash flow would look like if there were a disruption to income and capacity for a year or more. Some questions to consider in this exercise include the following: Where would funds come from to meet regular expenses? Would a disability affect access to employer-sponsored subsidized health insurance? Would expenses be incurred to fund childcare or housekeeping needs? 

This is an area where a small amount of preemptive planning can result in substantially reduced stress and cost if a disability event does occur.  

What are some strategies to protect against disability?

Disability insurance is the most direct protection someone can have against this risk. The basic premise of disability insurance is simple: It pays a benefit to the insured when they are unable to work. While the premise is simple, the details for these types of policies are complex and critical to how useful they would be if you needed them. Some of the thorny questions that a policy has to answer include: 

• Exactly how is disability defined and who makes this determination? 

• How much does the policy pay relative to the insured’s previous income? 

• How long must a disability last for benefits to be paid? 

• Once started, what is the duration of benefit? 

• Under what circumstances will benefits stop? 

• Will a policy’s benefits be reduced if the insured receives income from other sources such as Social Security Disability? 

These and many other issues can easily lead workers to avoid the topic of disability insurance altogether. A competent advisor will be able to assess your situation and help you evaluate the options to find coverage that meets your needs at a cost that is competitive with the market and that will not disrupt your other goals.  

In addition to disability insurance, several other pieces may be put in place to lessen the impact of a disability event. An appropriate emergency fund will provide resources to fund expenses during a short-term disability or while waiting for insurance benefits to kick in. Health insurance will fund a portion of healthcare expenses that are often concurrent with a disability event. While often associated only with care needs in old age, long-term care insurance may assist in paying for custodial care that may be necessary during a loss of capacity, even if the need is temporary.  

How does life insurance impact my portfolio?

Compared to disability, the same SSA study referenced above indicates a substantially lower risk of premature death during working years at 13% to 18%, with chances increasing with age. As with a disability event, the impact of premature death varies tremendously based on circumstances, and many of the same questions apply in assessing the overall risk to one’s plan. The ultimate goal of planning around premature death is to ensure that funds are available to meet expected needs without draining the portfolio assets set aside for long-term goals, such as retirement.  

Compared to disability coverage, insuring against premature death is relatively straightforward. Term life insurance coverage is generally quite affordable as long as there are no serious health conditions at play and the contracts are easier to understand. Your advisor can help you determine the right amount of insurance and, when working with your insurance professional, determine the best type of coverage to meet your needs. As discussed below, care should be taken to set up the policy in the best way possible, with the right ownership designation and appropriate beneficiaries in place. 

How does estate planning impact my investments?

While less obvious than the direct loss of income resulting from premature death or disability, having appropriate estate plans in place may also serve to protect portfolio assets. While living, incapacity can result in a significant financial cost if appropriate documents are not in place to allow others to manage your affairs. Reckless spending or gifting is often associated with cognitive decline. The use of living trusts and power of attorney documents can make it easier for loved ones to step in and help protect portfolio assets in the event there is a household member with diminished capacity. The right beneficiary designations can also make a large difference in the amount of taxes owed at death and by heirs in the future. Preserving even a small amount of portfolio assets at death by reducing taxes can have a significant impact over time, given the power of compounding.  

Is inflation the quiet killer of portfolio value?

In contrast to disability and death, which can cause obvious and immediate damage to accumulated portfolios, inflation is a quiet force that can greatly diminish the real value of your investments over time. The Bureau of Labor Statistics, among many others, publishes a calculator comparing the real value of a dollar over time. You would need $2.16 in 2024 to match the value of $1 in 1994, and this was a very mild inflationary period relative to the historical norms. Looking over the previous 30 years, you would need a full $4.83 in 1994 to match the value of $1 in 1964. Looking over the full 60-year period from 1964 to today, a reasonable time span for many portfolios from accumulation through retirement, you would need a whopping $10.20 in 2024 to match the value of $1 in 1964.  

As recent history makes clear, inflation can rear its head at any time, with any number of proximate causes, from policy decisions to geopolitical actions to global pandemics. To protect against this risk, a portfolio can include investments that hedge against inflation while providing the opportunity for growth over and above the rate of price increases in order to add real value over time.  

Stocks work very well here, as they benefit from inflation in two ways. First, as prices charged by companies rise, earnings often increase as well, leading to higher valuations of stock prices. Second, dividends tend to increase in higher-interest-rate environments associated with inflationary periods, adding additional portfolio income and further increasing stock prices due to the value of the higher dividend. To be sure, there are temporary periods of time where these relationships break down, but over time, stocks are a proven way to retain the real value of a portfolio and achieve growth over and above the rate of inflation. 

Commodities are often cited as an effective hedge against inflation as well. While it is true that prices of raw goods such as oil, copper, and gold do track inflation in most time periods, they do not necessarily increase in real value over time, as they have no earnings or cash flow to support their value or long-term growth. Even the price of gold, which is classically thought of as a supreme inflation hedge, has a less consistent relationship to prices than may be believed, as one very technical study points out.  

What to do next? 

Writing about risks comes with its own, well, risks. Using fear to inspire action feels distasteful, and none of us relish examining all the ways our carefully laid plans can go wrong. Please be assured that our goals as planners in examining topics like these are not to be doomsayers or salespeople feeding on fears; rather, it is to be clear-eyed and prepared for the best and worst that time may bring to those we advise, even when it means confronting topics we would prefer not to think about at all. The good news for anyone embarking on a review of their own circumstances is that planning for these events does not take very much in the way of regular action or maintenance. Once in place, a solid plan to protect against these risks should not need much attention for years to come and is likely to need substantial revision only in the case of significant life events.  

As in many areas of planning, there is a lot to consider when it comes to planning around risks to your portfolio. The good news is that you don’t have to do it alone. If you would like assistance managing these risks or with any other area of your plan, please reach out to our team.