Do Your Retirement Investments Need an Upgrade?

The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article previously appeared on Nov. 7, 2017.

Since the end of the financial crisis, it's been hard to go wrong with most investment types. Stocks of all types and from nearly every geography have gone up, while bond prices got a boost from declining interest rates. Unless you've had money under the mattress (or in cash) or sunk your whole portfolio into gold and commodities, it's a good bet that you've made money in your retirement portfolio over the past eight years.

However, I think it's also likely that the next eight years won't be as forgiving. The Federal Reserve has begun to tighten interest rates, meaning that bond investors are unlikely to continue to benefit from rising bond prices as they have over the past several decades, even though higher yields will be welcome. Stocks have continued their streak, but current market valuations aren't all that encouraging.

A less-forgiving environment means you'll need to get even pickier about the investments in your portfolio. As you review your portfolio holdings today, here are the key steps to take to ensure that your portfolio is in tiptop shape for what lies ahead.

Step 1: Enter your holdings in X-Ray. To begin reviewing your portfolio, enter each of your holdings in Morningstar's Instant X-Ray tool. Include IRAs, 401(k)s, and other tax-sheltered accounts that you hold, in either your own name and that of your spouse, as well as any taxable accounts.

If you like to maintain each of your accounts as distinct subportfolios on Morningstar.com--and that can be useful from a monitoring standpoint--you can do so. You can then use the "Combine" feature of Portfolio Manager to look at them as a unified whole. (Don't worry--"Combine" doesn't affect your subportfolios.)

Step 2: Assess allocations. Looking at all of your holdings in aggregate enables you to see a few key items. First, you can view your current combined balance--a helpful data point if you're doing the sort of wellness checkup we discussed earlier this week. (This article is geared toward retirement accumulators--people who are still working--and this one focuses on retirees.)

The X-Ray functionality, in particular, can help you get a look at your portfolio's weightings, at a very high level. First and foremost, you'll want to pay attention to your portfolio's stock/bond/cash mix. The beauty of X-Ray is that drills into each of your holdings' actual compositions. It doesn't just assume a large-growth fund is all large-growth stocks, for example, but instead can pick up on whether it has cash, foreign stocks, or stocks from other style boxes.

You can then compare your total retirement portfolio's current allocation with that of your targets; I discussed assessing your portfolio's asset allocation in this article. If you've been taking a hands-off tack with your portfolio in recent years, your equity weighting is apt to be higher than you intended. Keep an eye on your foreign versus U.S. stock split as well; many U.S. investors maintain a heavy bias to U.S. stocks. That can be helpful at times, but has the potential to reduce diversification and detract from returns at other times, too.

In addition to assessing the appropriateness of your baseline asset allocation, pay attention to whether your portfolio is adequately diversified. Are you courting any inadvertent sector or style bets, which can bring extra volatility? We're coming through a period in which large-company growth stocks--and technology and healthcare names in particular--have performed much better than other categories. Hands-off investors may find their holdings in those areas have enlarged at the expense of other worthwhile positions. X-Ray enables you to see your portfolio's sector weightings relative to the S&P 500. For context on the style box view, the U.S. market currently has about 24% in each of the large-cap boxes, 7% apiece in the mid-cap squares, and 3% each in the small-cap boxes.

Step 3: Review holdings' fundamentals. Next, cast a discerning eye on your holdings. Don't be blinded by recent performance, but instead focus on your holdings' fundamental qualities. Morningstar Analyst Ratings--star ratings for stocks and the Medalist ratings for mutual funds and exchange-traded funds--are a valuable way to size up your holdings' quality at a glance. For funds and ETFs, the ratings take into account expenses, management and parent company, the reasonableness and riskiness of the portfolio and strategy, and past performance. For individual stocks, the star ratings weigh a company's current share price against its likely future cash flows. If the preponderance of your holdings are stashed in Medalist funds and ETFs, and/or stocks rated 3 stars or more, that's a good indication that you're on the right track. Don't consider it a red flag if a stock or fund you hold doesn't have a rating; that simply means that it's not under coverage. However, if you see several 1- and 2-star stocks, or fund and ETF holdings that are rated Neutral or even Negative, that's a signal that pruning and upgrading is in order.

If you have mutual funds or ETFs in your retirement portfolio, another quick and dirty way to gauge holdings quality is to do an expense audit. Toward the bottom left of the X-Ray page, you can see an asset-weighted expense ratio for your portfolio; at a minimum, yours shouldn't be any higher than the average for a similarly weighted hypothetical portfolio, and ideally it would be well lower. With many ETFs and index funds providing broad stock- and bond-market exposure for well less than 0.10%, there's no reason to pay more than you have to. Morningstar's research has found a tight correlation between lower expenses and better performance. Moreover, if market returns are lower going forward than they have been in the recent past, paying less is a painless way to improve your take-home return. Morningstar director of fund research Russ Kinnel puts low costs at the top of his list of criteria when he screens for top mutual funds in his annual list of the best offerings.

My model portfolios can provide another check on your holdings and your portfolio's positioning given your life stage; they're composed of mutual funds and ETFs that receive high ratings from Morningstar's analysts.

Step 4: Mind tax matters. If you've reviewed your holdings and determined that some changes are in order, whether a few minor tweaks or a more substantive overhaul, the good news is that you won't face tax consequences for making the upgrade, provided the money stays within the confines of your IRAs, 401(k)s, or other tax-sheltered wrappers. In other words, there's no reason to put up with laggard holdings.

On the other hand, if you identify problem spots in the taxable portion of your portfolio, you'll want to exercise caution before initiating major changes. Unless you qualify for the 0% capital gains rate that prevails for investors in the lowest tax brackets or have large losses elsewhere in your portfolio (unlikely), selling appreciated positions from your taxable accounts is likely to trigger a tax bill. Check with a tax advisor before initiating big sales and look to adjustments in your tax-sheltered holdings to help address any problems with your asset allocation or sub-allocations.