Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

August 22, 2016

Chris Haverland, CFA®, Global Asset Allocation Strategist

What is Your Risk Tolerance?

  • When planning for long-term financial success, your investment goals are one of the first things to determine.
  • It also is important to determine the level of risk you are willing to take in order to achieve those goals.

What it may mean for investors

  • Whether your risk tolerance is conservative, moderate or aggressive*, we believe that diversification can help you to manage risk.

*Investment Objective name change, from Long Term to Aggressive, will appear in client accounts in November.

When planning for long-term financial success, your overall investment goals are one of the first things to determine. Are you more interested in generating income, growing your assets or a blend of the two? This decision is key to setting an appropriate strategic asset allocation. It also is important to determine the level of risk you are willing to take in order to achieve those goals. Your risk tolerance can be conservative, aggressive—or somewhere in between. These risk categories can be defined as:

  • Conservative— investors generally assume a lower amount of risk, but may still experience losses or have lower expected returns.
  • Moderate—investors are willing to accept a modest level of risk that may result in increased losses in exchange for the potential to receive modest returns.
  • Aggressive— investors seek a higher level of returns and are willing to accept a higher level of risk that may result in greater losses.

These risk classifications can be paired with your investment goal—as income-oriented or growth-oriented investors may be conservative, moderate or aggressive depending on variables such as their time horizon and liquidity needs. Conservative investors generally have a lower risk tolerance and may invest in assets with less potential volatility than others with a similar objective. Investors with an aggressive risk preference generally are willing to take on more volatility within their objective to increase income and/or returns.

Time horizon can influence an investor’s willingness to take risk and is one component that can help to align investment goals with risk tolerance. Financial markets can be extremely volatile on a year-to-year basis, and some investors may be unable to withstand sizable portfolio declines, even if those moves are likely to be only temporary. Investors with shorter time horizons are more likely to have a conservative risk profile, while investors with longer time horizons often are willing to take on more risk and may be in the moderate or aggressive categories.

Chart 1. One Year Rolling Returns—January 1990 through July 2016Chart 1. One Year Rolling Returns—January 1990 through July 2016Source: Wells Fargo Investment Institute. Morningstar Direct, 8/17/2016. Please see disclosures for index definitions. The Moderate Growth and Income Three-Asset Group Portfolio composition is as follows: Barclays U.S. Treasury Bills (1-3 months): 3%, Barclays U.S. Aggregate Bond Index (1-3 year): 4%, Barclays U.S. Aggregate Bond Index (5-7 year): 16%, Barclays U.S. Aggregate Bond index(10 years +): 7%, JPMorgan GBI Global Ex-U.S. Bond Index: 3%, Barclays U.S. Corporate High-Yield Bond Index: 6%, JPMorgan EMBI Global Index: 5%, FTSE EPRA/NAREIT Developed Index: 5%, S&P 500 Index: 21%, Russell Midcap® Index: 9%, Russell 2000® Index: 8%, MSCI EAFE Index: 6%, MSCI Emerging Markets Index: 5%, Bloomberg Commodity Index: 2%. Past performance is no guarantee of future results.

Regardless of risk tolerance, investors may be able to minimize volatility through asset-class diversification. The Great Recession showed us just how cruel the equity markets can be—with portfolio declines of greater than 40 percent in some cases. Many markets moved lower during that period. Yet some asset classes declined less than others, and still others experienced positive returns over this period. As Chart 1 shows, over shorter time horizons, higher-risk assets, such as equities, can experience significant swings in value. Portfolios that are diversified across fixed income, equities and real assets generally have seen less historical volatility. Fixed-income assets typically have low volatility; however, they may not provide enough return (alone) to meet long-term goals. This is especially true in today’s low-rate environment.

Looking out to a 10-year time horizon, the potential for loss is diminished as financial-market cycles evolve and many losses eventually turn into gains. There is greater potential reward in equities over these longer time horizons, but the risk also is higher. The diversified portfolio shown in Chart 2 has captured much of the upside without generating a loss over any 10-year rolling period since 1990. Over the same period, average annual returns for this diversified portfolio have outpaced both the S&P 500 Index and the Barclays U.S. Aggregate Bond Index.

Chart 2. Ten Year Annualized Rolling Returns—January 1990 through July 2016Chart 2. Ten Year Annualized Rolling Returns—January 1990 through July 2016Source: Sources: Wells Fargo Investment Institute. Morningstar Direct, 8/17/2016. Please see disclosures for index definitions. The Moderate Growth and Income Three-Asset Group Portfolio composition is as follows: Barclays U.S. Treasury Bills (1-3 months): 3%, Barclays U.S. Aggregate Bond Index (1-3 year): 4%, Barclays U.S. Aggregate Bond Index (5-7 year): 16%, Barclays U.S. Aggregate Bond index(10 years +): 7%, JPMorgan GBI Global Ex-U.S. Bond Index: 3%, Barclays U.S. Corporate High-Yield Bond Index: 6%, JPMorgan EMBI Global Index: 5%, FTSE EPRA/NAREIT Developed Index: 5%, S&P 500 Index: 21%, Russell Midcap® Index: 9%, Russell 2000® Index: 8%, MSCI EAFE Index: 6%, MSCI Emerging Markets Index: 5%, Bloomberg Commodity Index: 2%. Past performance is no guarantee of future results.

Determining your investment goals and risk tolerance is an important initial step that can help lead you to long-term financial success. Even so, your goals and risk preferences can change over time, and your asset allocation should adapt accordingly. To manage risk, we believe that it is essential to diversify your assets— whether your risk tolerance is conservative, moderate or aggressive. We recommend reviewing your investment goals and risk tolerance with your financial professional on a regular basis to ensure that they are reflected in your current asset allocation.

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security.

Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.

Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Diversification does not guarantee profit or protect against loss in declining markets.

Definitions

An index is unmanaged and not available for direct investment.

Barclays U.S. Aggregate Bond Index is unmanaged and is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.

Barclays U.S. Aggregate 1-3 Year Bond Index is unmanaged and is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 1-3 years.

Barclays U.S. Aggregate 5-7 Year Bond Index is unmanaged and is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.

Barclays U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.

Barclays 1-3 Month U.S. Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non-convertible.

Bloomberg Commodity Index is a broadly diversified index comprised of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

JPMorgan GBI Global ex-US (Unhedged) in USD is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

JP Morgan Emerging Markets Bond Index Global (EMBI Global), which currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000® Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company.

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