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4 portfolio risks and how to manage them

CHAPPAQUA, N.Y. (MarketWatch) -- When you check to see if your portfolio's mix of stocks, bonds, and cash is right for someone in your circumstances, don't stop there.

Take the time to study the risks inherent in your mutual funds -- which is a required disclosure in fund literature and on fund-company Web sites -- to determine if there's anything amiss that could derail your goals.

A few examples are timely:

1. Interest rate risk: Get familiar with a complicated measure called duration, which indicates the sensitivity of a bond or bond fund to a change in interest rates.

The longer the duration -- expressed in years, as maturities are, but not the same -- the steeper the price decline as rates rise (and vice versa). Unfortunately, high credit quality does not protect you from a plunge in prices of long-term issues.

How do you mitigate interest rate risk? Align durations with your investment horizon -- short-term bonds for a short-term plan; intermediate-term for longer.

2. Currency risk: In addition to the risks they share with domestic stock funds, world equity funds pose the risk that a rise in the U.S. dollar's value against other currencies could cause returns on foreign stocks, expressed in local currencies, to suffer when translated into greenbacks.

To cope with currency and regional risks, limit exposure to foreign stock markets -- but not to prospering global economies -- by owning domestic funds invested in strong U.S.-based companies that operate internationally and may hedge foreign currency exposure.

3. Investment style risk: Growth-stock funds are expected to own stocks that can grow faster than an economy, while value stock funds are supposed to buy stocks that sell at discounts to an estimate of their true value. These are called "style" funds.

Owning a growth fund when value funds are hot (or vice versa) -- that is, being invested in an out-of-favor investment style, then rushing to an in-favor style leader, and then switching to keep up with style leadership rotation is a recipe for high trading costs and possibly investment losses.

The landscape changes frequently, as indicated by Russell growth and value stock indices, classified according to capitalization. Over the past 10 years, growth and value indices each led five times, and neither style stayed on top for more than two consecutive years.

Is style-consciousness worth the effort? Over the decade ended June 30, growth indices led their value peers, but value was close.

If you believe your portfolio is underexposed to either style and want a growth or value fund to correct that, why not plan to hold it as long as its performance is satisfactory?

4. Unsuitable investment risk: When securities markets offer low bond yields, volatile equity returns, or both, you may be tempted by investments that appear to meet your needs but are in fact unsuitable.

Say you replace equity funds with municipal-bond funds because the stock market is volatile and the muni interest is tax-free. This ignores why you bought suitable equity funds: for long-term appreciation and income, plus inflation protection.

Cash dividends from well-chosen stocks have a good chance of rising over time, but a bond's payment is fixed till maturity. Moreover, pocketing capital appreciation from bonds would require lower interest rates, which is an unlikely prospect at this point.

Yields of tax-exempt municipal bonds tend to be lower than yields of comparable taxable government and corporate bonds. Do the math to check which type is more suitable for you. Here's the formula: Tax-equivalent yield equals tax-free yield divided by (1 minus your federal income tax bracket). For the most accurate picture, factor in your state's income tax percentage as well.

Nowadays you'll find an oddity: Treasury yields have been hammered so low that they are below tax-exempt yields of comparable maturities -- and that's before tax on Treasury interest payments.

Werner Renberg is a freelance financial writer, based in Chappaqua, N.Y.