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By Jason Stipp | 05-11-2011 04:01 PM

Portfolio Makeover Preview: Under the Hood of a Makeover

Morningstar's Christine Benz describes the process of assessing, testing, tweaking, and upgrading investment portfolios for specific goals.

Jason Stipp: I'm Jason Stipp for Morningstar. Starting on May 16, it's Morningstar's Portfolio Makeover Week. Every day this week Morningstar's Christine Benz is going to make over a real life investor's portfolio, and outline some of the dilemmas, and offer some solutions to some of the dilemmas, that they face.

She's here with me, today to talk about her process in doing the Portfolio Makeover.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, you hear from a lot of readers and a lot of them ask for some tips in making over their portfolio. What are some of the first things that you like to do when you are undertaking a portfolio makeover to get going? How do you lay the groundwork?

Benz: Well, step one is to gather information, and this is really the first step that any financial planner or advisor should be using, and most are using. So, when you sit down with an advisor, they ask, what are you trying to achieve, what are your goals, what falls under the category of "nice to have" and what's must have for you, and also what's your pool of investments?

So, I'll start with a user talking about what their current starting point is in terms of their investment mix--specific holdings, as well as where they are holding them in terms of taxable and tax-sheltered accounts.

Stipp: And a lot of investors will come to you with some preconceived preferences for how they invest. What do you like to find out about their current style?

Benz: Well, I like to find out whether they want to be hands-off or more hands-on, and for a lot of users, it's a combination. So, some have stocks and mutual funds together. So investment style, also investment type preferences, stock investors versus ETF or fund investors. A lot of our users say, "I'm very into low-cost index investments, so let's stick with that."

My goal, when I look at these portfolios is not to make major changes, unless we have to or unless they look like they really must be done.

So, I try to keep things intact as much as possible, especially if the user likes what he or she has or at least likes some of the holdings.

Stipp: I know that sometimes the decisions that are made for a portfolio depend on the type of account that it's in.

Benz: Right.

Stipp: ... So what do you need to learn about where this money is located?

Benz: Well that's the thing. For some users they have assets within say 401(k) plan where they are choosing from a preset menu of choices. So, if we're trying to make some changes to that part of the portfolio, we'd need to know, okay, what's the opportunity set for you. Sometimes we may be constrained and may not love the choices, but we can usually come up with a pretty sensible mix.

Sometimes if its someone who comes in with a stable-value fund within a 401(k), that's usually a really good thing that we want to try to hang on to, because it's hard to replicate that type of investment outside of a 401(k) plan. So where they are holding the assets is really important.

Stipp: Another important piece is not only the portfolio's allocation and how much is in it, but also how much is coming in and how much is coming out.

Benz: Right, right. So, if it's someone getting ready to retire and a lot of people who want to talk about thinking about making over their portfolios, they are at an inflection point in their life, oftentimes getting close to retirement or at least thinking about retirement. So, at that point, we say, "OK, what kind of income demands will you be making on this portfolio? Is your current portfolio on track to get you to that target income rate?"

If it's someone still saving, we'll want to hear about, how much are you saving and also, where are you saving? So, are you optimizing those tax-sheltered vehicles that are available to you.

Stipp: Lastly, on that first step of getting the lay of the land is something that some people might think you would have put first, but you don't. And that's the risk tolerance. Why is the risk tolerance something that you try to get a feel for, but not the first thing?

Benz: Right, I like to hear about risk tolerance, but I think for a lot of investors they put too much credence in their risk tolerance and oftentimes that can lead them to an overly aggressive or overly conservative asset mix. So oftentimes the risk tolerance is not the best guide to asset allocation; it's secondary in my view.

Stipp: So, the second big step is figuring out, is this general portfolio going to get them to where they are going? Obviously, that's the big question that most people have about their portfolios. How do you get a sense of where they are going and if they are going to make it?

Benz: Right. So, that viability question is absolutely key. What I use, and this is what I would say anyone should do, if they are looking at their portfolio and trying to see if it will meet their goals. I sample a range of different tools available on the web. I turn first to Morningstar's  Asset Allocator tool typically.

The nice thing about Asset Allocator is that, if I already have the portfolio plugged in to Morningstar.com, I can rely on it, the actual portfolio, to see if that's going to meet the income demands during retirement. Or if it's someone who wants a fixed dollar amount, I can see whether that current portfolio is positioned to at least have a decent probability of meeting that person's income needs.

Stipp: So, sometimes I would imagine that someone will come to you and it's pretty clear that they could probably make their needs with a certain portion of the portfolio or a pension or something like that. But in other cases, it might be the case that it looks like there could potentially be a shortfall or maybe you look at some of those calculators, and it doesn't look particularly sunny. A portfolio makeover can't perform miracles, though, right? I mean what other things might you have to take into account?

Benz: Well that's the thing. So, there are only so many adjustments that we can make that can deliver a better probability. So, once we run through those and see well, even if we kick up the equity allocation quite a bit, you still may not be able to retire on that date that you thought you would.

Then, we'll talk, and this is something I think any investor should run through in his or her mind. We'll talk about what are the other levers you can pull. Can you think about working part-time or even working a little bit longer and continuing to save, continuing to not have to tap your principal or possibly, if you are someone who lives in a very large home and all your kids are gone. Can you think about downsizing to a smaller home?

If it's someone who is still working and has quite a few years until retirement, we'll talk about jacking up the savings rate and making sure that they are taking advantage of all those tax-sheltered options that are available to them.

Stipp: The third big step, Christine, you mentioned that one of your goals is not to completely upend the portfolio, but sometimes some adjustments will need to be made. So, how do you go about looking at the current portfolio and deciding if it's going to be a bigger overhaul or maybe just some tweaks around the edges?

Benz: Well, I use Morningstar's X-Ray tool as a starting point. Instant X-Ray is a great way to load the portfolio into our Portfolio Manager tool. First and foremost, I am looking at the asset allocation. So, I'm looking at what Instant X-Ray says is the asset allocation. I'm looking at the style diversification that that portfolio has.

A lot of people right now, given the strong runup we've had in small- and mid-cap stocks have, probably, a disproportionate share of their portfolios there.

I'll look at manager diversification. So, I was recently corresponding with a user who has a lot of her portfolio staked with a single manager. That's something I will try to address as well.

So, a whole range of portfolio-specific factors.

Stipp: Certainly different folks at different life stages have a need to tap the portfolio closer to now and some have probably not a need to tap those funds for a while. What do you think about on that front?

Benz: Right. So, making sure we have that cash cushion in place if it's someone who is getting close to retirement or maybe has some other thing going on in their lives, so maybe saving for a home down payment. We will want to make sure that we have adequate cash resources carved out in that portfolio as well.

Stipp: What about number of holdings Christine, because I think a lot of people end up collecting investments after a while. Is there an optimal number, or how do you consider the number of holdings when you are thinking of the makeover?

Benz: Well, personal bias certainly plays in here as well. So, if it's someone who is a stock investor, for them to be able to achieve adequate diversification with that portfolio, they need to have quite a few stock holdings.

But generally my bias is "less is more," particularly for folks who are in retirement or even pretty far on in retirement, we want to start thinking about streamlining. My strong bias is toward a more streamlined portfolio, simply because that is easier to manage. It gives you fewer moving parts to oversee on an ongoing basis.

Stipp: Certainly you just can't look at the raw number. Some index funds are very, very diversified and some are much more narrowly focused. So, you could have one holding and have a lot of exposure, or you could have five holdings and have very narrow exposure.

Benz: That's right. So if someone is an index-centric investor, it's very easy to get the job done with just a handful of holdings.

Stipp: What about the quality of the holdings, Christine, and looking at expenses and things like that. What are some key warning signs there?

Benz: So, that's a big part of what I'm thinking about when I look at a portfolio. What do our analysts say about it? Do they like it? Do they not like it? If we don't cover it, I'll spend some time investigating it. Certainly expense ratio is an important characteristic when I look at mutual funds. We find it's one of the most predictive data points.

So, I try to stack the deck in the investor's favor by favoring low-cost investments, but definitely our analysts' view on various holdings is key for me. And if we are thinking about changing holdings, I'll definitely try to stick with our Analyst Picks list for funds, and the high-conviction list of stocks, 4- and 5-star rated stocks, if we're looking at stock portfolios.

Stipp: Okay, Christine, moving on to the next step is what I think of as the "tinkering" step, and this is where you're testing some different hypotheses. What happens when you're actually doing the makeover, how does that process work?

Benz: Well, it's definitely a process of trial and error. It involves some tinkering, and certainly if someone has a number of sub-portfolios going on, so maybe they have IRAs and 401(k)s, I'll create separate sub-portfolios and then use the Combine feature in Portfolio Manager to try to get a sense of the overall portfolio's asset allocation, but it's definitely a process of trial and error, particularly where you have actively managed funds in the mix that may have cash holdings, or maybe the investor has hybrid type holdings, that mix stocks and bonds, you're never quite sure how adding or subtracting from such holdings will affect your overall portfolio's asset allocation.

So, it definitely is a process of fiddling around, and anyone undertaking a portfolio makeover should be prepared to fiddle around a little bit. The Instant X-Ray tool makes it really easy to do, so you can go back and edit holdings, look at the X-Ray go back again. It's definitely a process of trial and error.

Stipp: Okay, so you have a lay of the land, you've gotten a sense of what the goals need to be, what the original portfolio was, what some of your targets are, you've tinkered a little bit, and you finally arrived at a good potential makeover portfolio. So what's the next step? Do you just wipe the slate clean and say, "I'm going to move everything over right now"? Or how should you begin to actually implement that new portfolio makeover?

Benz: That's a great point and particularly timely right now, so I am thinking about this set of portfolio makeovers that I have been working on. If we're making substantive changes to the stock or bond mixes, you want to be really careful because both the stock and bond markets are feeling pretty fairly valued right now.

So, my bias always, but especially in the case of portfolio makeovers, would be to use a dollar cost averaging program, particularly if we're talking about substantial sums of money or substantial percentages of people's portfolios that are changing. We would want to talk about executing them over a period of months or possibly even years, if it's a large portion of their portfolio. That way they can obtain a range of different purchase prices for those new assets.

Another key consideration is the taxable implications. So, if it's a person with a large share of their portfolio within a taxable account, we'll want to see if we can move the needle in terms of asset allocation by making changes in the tax-sheltered accounts first, where you would not pay any taxes to make changes to those parts of the portfolio. So, taxes are absolutely key.

Stipp: All right, Christine. Well, I am very much looking forward to your makeovers this week. Thanks for joining me today and the details on your process.

Benz: Thank you, Jason.

Stipp: If you'd like more details on how to do your own portfolio makeover, please be sure to tune into Christine's Premium Member webinar on Monday May 23. I'm Jason Stipp for Morningstar and thanks for watching.

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