Breaking the broader goal of better financial management into small(ish), more manageable steps was the impetus behind my 2017 financial calendar. At the outset of each month, I'll take you through key tasks that you can aim to knock off. Some of these jobs will be time-sensitive, such as tax and IRA-funding season, while others will be less so.
On the docket for February? Conducting a portfolio review and rebalancing.
Of course, many investors review their portfolios at year end, with an eye toward improving their tax positions. If you've checked up on your portfolio recently, there’s certainly no need to revisit it again.
But it's safe to say that a lot of investors have gotten complacent about the whole practice of reviewing their portfolios and making changes. With balances that have enlarged fairly steadily for nearly eight years, it has been tempting to leave well enough alone. Further compounding investors' tendency to stand pat is that even though their equity positions have gotten larger, the main alternative--bonds--hardly compel today, with their still-low yields and vulnerability to rising interest rates.
Many discussions of rebalancing are frustratingly one-dimensional, though. I firmly believe the type of rebalancing you engage in--and the urgency you feel about that practice--should vary by life stage. Retirees should absolutely take steps to de-risk their portfolios after strong equity-market rallies, paring back on stocks and boosting their weightings in cash and bonds.
Meanwhile, younger investors in accumulation mode will want to consider rebalancing within their large equity stakes; that type of rebalancing has the potential to enhance their returns, and may reduce volatility as well. For such investors, boosting international equities at the expense of U.S. looks to be a particularly smart move right now. This second type of rebalancing falls more into the category of "nice to have" than "must do," however.
Midcareer investors may wish to engage in both types of rebalancing. While taking some equity risk off the table may be appropriate, investors in their 40s and 50s might also tweak their equity allocations, pruning U.S. equities in favor of foreign, for example.
Here are the key steps to take as you review your portfolio and determine what, if any, adjustments to make.
Step 1: Get a Holistic View of Your Portfolio's Positioning
If you're assessing whether rebalancing your portfolio is in order, the starting point is to take a holistic look at all of the investment kitties you have earmarked for retirement: company retirement plans, IRAs, and taxable accounts, to name the key ones. The X-Ray functionality in Morningstar's Portfolio Manager tool--or alternatively, Instant X-Ray--can give you a read on your portfolio's baseline asset allocation, as well as subasset class exposures (investment style and sector positioning, as well as U.S. versus foreign stock holdings).
Step 2: Assess Positioning Relative to Your Benchmarks
On its own, X-Ray is a bit of a data dump; it's hard to know what to make of your portfolio's statistics without some benchmarks, especially for your asset-class positioning. In the past, I've suggested that target-date funds can serve as reasonable benchmarks for asset-class positioning. While they might not fit each and every situation, they generally include sensible glide paths for various life stages. Morningstar's Lifetime Allocation Indexes are another check on allocations. Focus on those products and indexes that match your anticipated retirement date. If you're very close to or in retirement, you can use your expected spending horizon to determine your portfolio's allocations to various asset allocations, or buckets, as discussed in this article.
The X-Ray tool shows you your sector positioning relative to the S&P 500. When it comes to investment style, a total market index can provide a reasonable benchmark; the U.S. market currently has 24% in each of the large-cap style boxes, 7% in each of the mid-cap squares, and 3% apiece in small caps.
There are varying approaches to apportioning equity assets across U.S. and foreign markets. Younger investors might reasonably use the "global market cap" approach, mirroring the composition of global equity markets. Right now, for example, the U.S. market accounts for roughly 55% of the value of the global equity market, with the rest in foreign-domiciled firms. Most professional asset allocation guidance doesn't stake as much in overseas stocks, however, in part because the U.S. market is quite well diversified by sector as well as because unhedged foreign-equity exposure courts currency risk. Vanguard maintains a roughly 60% U.S./40% foreign weighting for all of its target-date funds' equity positions. The Gold-rated BlackRock Lifepath Index target-date funds, meanwhile, feature gradually declining foreign-stock weightings; the funds for young accumulators have close to 40% of their equity portfolios in foreign stocks, whereas the target-date products geared toward investors closing in on retirement have 35% weightings. Morningstar's Lifetime Allocation indexes take a similar approach to their foreign stock/U.S. stock allocations, reducing foreign exposure as a percentage of the total equity position for older investors.
Step 3: Determine Next Steps Based on Your Life Stage
The next step in the rebalancing assessment is to determine whether any changes are in order. As noted, regular rebalancing among asset classes can help reduce risk in a portfolio, and therefore is particularly important for pre-retirees and retirees. Younger accumulators may also rebalance among asset classes, especially if they're bugged by short-term volatility. But such investors may want to put a bigger emphasis on enhancing return potential via intra-asset-class rebalancing.
For Pre-Retirees and Retirees (60s and beyond)
This is the cohort for whom traditional rebalancing among asset classes is the most urgent. After all, the stock market has risen, with just a few short interruptions, since March 2009, one of the longest rallies in stock-market history. Hands-off investors have been rewarded for letting their equity positions ascend, but it's likely they have more riding on stocks than they intended to. For example, an investor with 60% of her portfolio in a total U.S. market index fund and 40% in a Barclays Aggregate Bond index fund at the beginning of 2009, when stocks started to rally, would now have 80% of her portfolio in stocks and just 20% in bonds. At the same time, she's almost eight years older, so a more conservative, rather than a more aggressive, asset allocation is probably in order.
That's not to say every retiree and pre-retiree needs a massive dose of bonds and cash, though. As regular readers know, I'm a believer in letting your cash-flow needs determine how much to park in safe assets. Retirees and pre-retirees who will be drawing most of their living expenses from non-portfolio sources like pensions should have fairly small positions in cash and bonds, while those who are relying heavily on their portfolios should earmark more in safe securities.
Because many retirees want to maintain some liquid assets in their portfolios to meet regular living expenses, I like the idea of annually steering portfolio rebalancing proceeds into the portfolio's cash bucket. That takes risk out of the portfolio while also meeting cash-flow needs, as discussed in this article. Any assets not deployed into cash can be used to top up high-quality bonds.
Of course, retirees and pre-retirees may wish to engage in intra-asset-class rebalancing, too. But because their equity portfolios are a smaller percentage of their total portfolios than is the case for younger investors, those intra-asset-class tweaks will be less impactful.
For Early-Career Accumulators (20s and 30s)
Investors who have been investing for fewer than 10 years have seen the market move in a pretty lopsided direction over their time horizons: U.S. stocks have prospered at the expense of everything else, including foreign names. An investor whose equity portfolio was 60% U.S./40% foreign in early 2009 would now have 72% in U.S. stocks and 28% in foreign (assuming that investor used broad market indexes to populate his portfolio). Thus, investors who haven't revisited their foreign versus U.S. weightings recently may be able to improve their portfolios' return potential by trimming their U.S. equity holdings and steering the proceeds to foreign. Indeed, in my recent survey of return expectations for the major asset classes, most of the market experts anticipated better returns for non-U.S. stocks than for companies domiciled stateside. Investors who maintain separate developed and developing foreign-equity holdings may be able to further amp up returns by emphasizing developing markets, which have dramatically underperformed developed over the past several years.
Very early accumulators(for whom new portfolio additions represent a significant share of their balances may be able to move the needle on their portfolios' U.S./foreign ratios by simply steering new dollars to foreign stocks and funds. Accumulators with larger portfolios may have to shift around existing holdings to hit their target reallocations. Tax-sheltered accounts like IRAs and 401(k)s are ideal rebalancing spots, because selling appreciated securities doesn’t carry any tax consequences.
For Mid- and Late-Career Accumulators (40s and 50s)
Mid- and late-career accumulators can reasonably use rebalancing as an opportunity to multitask, tweaking their baseline asset allocations as well as their suballocations. While de-risking is less urgent than it is for pre-retirees and retirees, it's still worthwhile, especially for people in their 50s and/or those who have been rattled by previous market shocks.