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By Jason Stipp and Christine Benz | 03-27-2013 03:00 PM

Benz: Top Tips for Your First-Quarter Portfolio Checkup

After a strong first quarter, size up your allocation mix, fixed-income exposure, international positioning, and more with these pointers from Morningstar's director of personal finance.

Jason Stipp: I'm Jason Stipp for Morningstar.

As we approach the close of the first quarter, we're up about 10% over the first three months of 2013--this on top of a 16% gain for the S&P 500 in 2012.

So, what does it mean for your portfolio, as you're cracking open the paperwork to see how you did in the first quarter? Here to offer some insights is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So stocks have had another strong period of performance here. As you're opening your portfolio, you may have seen some shifts in your asset allocation because, simply, of the market forces at work in the first quarter. What kind of divergence before I start to really think I need to readjust my allocation? How do I know if I'm off target essentially?

Benz: Well, I think the starting point is to look at your portfolio through our X-Ray tool, so you can either get in through Portfolio Manager, or use the Instant X-Ray tool on the Tools tab of the site. So look at that X-Ray, compare it to your targets for the major asset classes. If you don't have targets, really make that the starting point in this process; get some targets for what is an appropriate asset allocation given your time horizon. So do that comparison.

I think what you're looking for before you make changes is, divergences of, say, 5 percentage points, or maybe event 10 percentage points versus your targets. So if your target for equities is 40% and you're up at 52% now, it's probably time to make some changes. You don't need to be monkeying around, though, if your divergences are more in the neighborhood of 3% or something like that. [In that case,] it's probably worth just letting things right a little bit before you get in and make changes, because changes may incur tax costs, and they may incur transaction costs. So you want to use a light hand.

Stipp: So stocks have done well. So a likely possibility when you look at your portfolio is that you're light on bonds because of that stock performance. What should I do if that's what I see, if I'm outside the range of the 5 to 10 percentage points, as you recommend?

Benz: I think it's time to rebalance if you do see that big divergence, and that's particularly pressing if you are getting close to retirement and you're someone who needs to take risk off the table--don't delay in de-risking.

Though I would say if you are someone who does need to peel back on equities and move money to bonds, and you see a really big gap between what you have in bonds and what you need to have in bands, you probably want to move at least some of that money into cash, and then dribble it into the bond market over a period of months. Use a dollar-cost averaging strategy there.

The other point I would make, Jason, is that at a time like this, where the risk-reward profile for bonds isn't particularly attractive, you want to remember why you have bonds in your portfolio. It's there for stability--maybe a little bit of income--but stability and diversification relative to your equity holdings. So I think if you're adding to fixed-income holdings right now, you really want to think about making it short term and pretty high-quality, rather than adding to risky parts of the fixed-income market at this point.

Stipp: On the flip side, if I look at my portfolio, what if I seem to be light on stocks? We have seen a lot of people putting additional money to work into fixed income, so although stocks have had a good run here in the first quarter, it is possible that when you look at those allocations, stocks might be on the light side.

Benz: That's right. There are still some people who got risk out of their portfolio back in the bear market and never fully got back in. So stock aren't a screaming buy right now, and they're looking at what they should do with their portfolios. For them, again, I think a dollar-cost averaging strategy makes a lot of sense, getting a plan for topping up the equity allocation and doing so over a period of months.

I think it also makes sense to pick your spots, if you're adding new money to equities at this point. So you look on the first quarter's performance, and what you see is actually that value stocks generally outperformed growth, and small- and mid-caps generally outperformed large. So you might think about putting money to work into larger-cap investments, as well as those with a little more of a growth tilt.

One idea that I think is interesting right now is … there are a few contrarian-type growth funds out there. One I would point to is PRIMECAP Odyssey Aggressive Growth. That's a fund that invests in growth stocks, but it looks for them to be relatively cheap. I think that's a really interesting strategy in a market like the current one.

Stipp: Another thing that you want to consider as you're looking at your portfolio at a high level is your international exposure. Now here at the end of the first quarter, international issues came back to the forefront again, especially in Europe. What should I be thinking about my international positions?

Benz: Well, I think that a lot of portfolios may indeed be light on international stocks relative to people's targets. One thing people should keep in mind is that when you think about the U.S. as a component of the total market capitalization, it's less than half. So if you are dramatically over-weighted in U.S. stocks relative to foreign, if you're upwards of 80%- 90% U.S., it's probably a reasonable time to think about adding more international exposure.

I take comfort in reading [Morningstar vice president of global equity and credit research] Heather Brilliant's words about the price to fair values for various market sectors. What she found is that European stocks are generally trading at a small discount to U.S. in terms of their price to fair values, and Asian stocks are also looking relatively inexpensive. No screaming buys here, unfortunately, but I think that that price to fair value metric is a good case for maybe adding a little bit more to international.

Stipp: So maybe looking at a value-oriented international manager, maybe one of Morningstar's medalists, could be a way to get some exposure there.

Benz: I think that's a great idea, and also thinking about a fund with some exposure to emerging markets, because we have seen a general trend toward underperformance among emerging markets recently. There are periods when emerging markets get super-expensive. They don't appear to be right now.

Stipp: Christine, if I'm like most of Morningstar readers, income has been one of the things I needed to get out of my portfolio. As I'm looking at the yield profile and where I'm taking my risk in income investments, what should I think about in doing this checkup?

Benz: I think great care is in order at this particular time, particularly on the fixed-income side. I just did a quick scan, Jason, of some of the high-yield funds that we like and what their yields look like right now. You're seeing yields under 5%, in some cases under 4%, currently. The risk is that you just don't have much of a cushion. If company balance sheets start to weaken or if, in fact, interest rates jump up, high-yield bonds just don't have the cushion that they have had at various points in the past. So the risk-reward profile for risky fixed-income assets just doesn't seem very attractive right now. I think it's really important to stay attuned to … if you do have some of those noncore fixed-income types in your portfolio, that you're limiting your exposure. You'd want to think of them as maybe 10%-15% of your total fixed-income portfolio. You don't want them to be any larger.

Stipp: Lastly, Christine, a big part of success for me as an investor is not making mistakes. So it's getting certain things right and also avoiding problem areas.

As I'm making changes, and around the end of the quarter, the end of the year might be a time I make changes, how can I make sure I don't fall into some kind of a trap or make a wrong move here?

Benz: I think mental mistakes are a big risk when you've come through a period, not just in the first quarter, but last year, the markets have been great. So people fall into some of these mental traps. One of the big ones is overconfidence--simply believing that you're better than you are, because really when you look back on 2012, it was hard to make a wrong move. Bonds did all right; stocks did very, very well. So some people might be thinking that they're kind of smarter than they are, unfortunately. So I think one thing you can think about is just making sure that you're benchmarking yourself fairly and honestly. So make sure that you have a target benchmark that you've set up that mirrors your own asset allocation, but maybe uses  inexpensive index funds. Also comparing your performance to that of a good target-date fund, I think, is a great idea if you're concerned about overconfidence perhaps overwhelming your portfolio maneuvers.

Stipp: One thing that can happen when stocks are doing well is we get something called "the wealth effect," which everyone feels a little bit wealthier. Home prices are also appreciating, which can contribute to that. What should I think about to make sure I don't feel too wealthy perhaps?

Benz: Well, I think the big risk of that wealth effect is that you do overspend. So you think, well, my 401(k) looks really good, I'm well on track to my retirement plan. So I think the key thing is that you have a budget and also that you are sticking to it regardless of what your long-term portfolio is doing.

Stipp: Also, just because the market has done well recently, that shouldn't necessarily affect when you choose to begin to retire, right? So that could be a mistake if you think, hey, the markets are up; now is a great time to just take an early retirement.

Benz: Right. In fact, our colleague, Adam Zoll did an interview with a retirement expert recently, and what she found was that people do tend to retire in periods after the market has performed very well. The problem with that is that if they do intend to leave some money in the market, that's actually not a great time to retire. Somewhat counter-intuitively, you're better off retiring in markets that are not that great or markets that are sort of middling, versus those where your portfolio might be sort of peaking.

Stipp: OK. Christine, some very important and practical tips for your portfolio checkup after what has, again, been a very good first quarter. Thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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