Note: This video is part of Morningstar's January 2015 5-Point Retirement Portfolio Checkup special report.
Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar.com's [5-Point] Retirement Portfolio Checkup week, we're helping investors assess their asset allocations, their individual positions, and also size up some of the risks that might be lurking in their portfolios. And with stock and bond markets both performing well over the past five years, there could be some of those risks lurking. Here to talk about that is Morningstar's Christine Benz, our director of personal finance.
Christine, thanks for being here.
Christine Benz: Jason, great to be here.
Stipp: It's almost counterintuitive that when markets are doing well, risks start to get baked into them. But that is the case, especially when it comes to valuation, and you say valuations are one of the first risks that you really want to size up in your portfolio right now.
Benz: That's right. You can look at valuation on sort of a macro level. When we look at the typical company that our analysts cover, the price/fair value is 1.03. Not egregiously expensive, but by other measures, stocks do appear somewhat expensive. The Shiller P/E, which is a cyclically adjusted price/earnings ratio, historically has been in the neighborhood of 16. Right now, it's 27. A lot of people who are valuation-conscious have been pointing to that as a potential red flag for equity valuations. But I do think it's a great time to step back. Just from a common-sense standpoint, we probably will see some reversion to the mean. We've been through a period where equities have performed very, very well for a long period of time. We are starting to see some volatility here in 2015's early innings. I think it's only reasonable to expect that we will see more volatility ahead.
When we do have those periodic market shakeouts, they tend to affect the most highly priced pockets of the market the most. So, those are the things that go down the most. I think that that pattern will probably persist in the years ahead.Read Full Transcript
Stipp: So, many signals are pointing to at least a fully valued market, if not an overvalued market. So, looking at that, what should I do about that risk? It does seem like it is a pertinent risk right now.
Benz: Absolutely. The key thing you want to do is look at your total asset allocation--I like our X-Ray tool for getting a read on your portfolio's current asset allocation. Compare it to your target. For many investors who have been pretty hands-off with their portfolios, that's been a very good thing over the past five years; you've been better off just kind of letting your equities ride. But I do think periodic rebalancing can make a lot of sense. So, consider rebalancing back to your targets--that's job one.
For most investors, that will require them to kind of hold their nose and rebalance, because chances are if they have bonds in their portfolios, that bond piece will have slumped; they'll have to top that piece up--as well as foreign stocks. Foreign stocks have underperformed U.S. There are a lot of gloomy-looking headlines coming out of foreign market, certainly in Europe as well as slowing growth in emerging markets. But I think there, again, investors have reason to consider scaling back their U.S. equity exposure in favor of perhaps foreign stocks or bonds.
Stipp: So, assuming that my situation hasn't changed and my targets are still correct, I should rebalance back to those targets; but I shouldn't necessarily exit stocks or change my plan just because markets look a little overvalued?
Benz: Absolutely not. In addition to doing that rebalancing check--comparing your asset allocation to your target--you also want to look at your intra-asset-class exposure, your intra-equity exposure. I think it's reasonable, given the robust returns we've seen from stocks for so long, that investors should shade their portfolios toward the value side of the style box. I think some would argue that that's a reasonable thing to do all the time. But particularly right now, when we isolate the value companies in our coverage universe, typically we see lower price/fair values there, as you would expect, than on the blend and growth sides of the style box.
So, I think that that's another thing to think about: In addition to looking at that asset-class exposure from a macro level, also look at what you've got going within your equity portfolio.
Stipp: And you maybe want to tilt away from some areas that look overvalued or maybe even more overvalued than the market as a whole?
Benz: Potentially so. When we look at the most overvalued sectors--again, based on our bottom-up look at the companies' price/fair values--what we see is some level of overvaluation in the utilities. That's the most overvalued sector, according to our equity analysts currently. Real estate is another [overvalued] spot; our analysts think, generally, the REITs are a little bit ahead of themselves. The consumer defensive and health-care sectors would be two other areas that investors might consider trimming. Performance has been very, very good, but perhaps it's time to pare it back and steer some money toward other parts of the market.
Stipp: And make sure when you're doing your rebalancing not to overlook overseas investments. Those haven't looked as hot recently.
Benz: They haven't. And certainly, you might address that as part of your rebalancing program--look at where your foreign-equity exposure is versus your targets. I did an interesting article just this past week where we looked at world-allocation funds and where our top-rated world-allocation fund managers are placing their bets these days. One thing that jumped out loud and clear is that these are managers who can go anywhere and, generally speaking, they are preferring foreign equities to U.S. equities right now. I think that probably is largely an outgrowth of valuation considerations.
Stipp: So, valuations do look pretty full right now. Maybe expect some volatility. It seems like there are some opportunities here to sort of tactically rebalance, if you will.
Stipp: Another risk, though, that probably isn't on a lot of folks' minds is inflation risk because we haven't seen a lot of it, especially recently with oil prices coming down. But that doesn't mean you should ignore it as you're doing a risk assessment.
Benz: That's right. Inflation has been very, very low, and one thing we've seen when we look at flows going in and out of funds is that investors seem to be abandoning a lot of investment types that they would typically use as hedges against inflation. So, we've seen pretty strong outflows coming out of Treasury Inflation-Protected Securities funds--also commodities funds. Certainly, performance hasn't been great in either of these areas. Commodities, especially, have been affected by slumping energy prices, so investors appear to be kind of giving up on these inflation hedges--and there might be some rational reasons to do so. I think the key thing that they want to keep in mind, though, is that the prices have become depressed as well. So, is it necessarily a good time to be giving up on some of these categories if you know, in the long term, you want them to be part of your portfolio?
Stipp: So, inflation protection is like buying insurance. And if insurance is cheap, maybe it's a good time to buy some of it, if you want that protection in the long term. So, let's talk a little bit about how I size up this inflation risk. The first thing is how concerned should I be about inflation? It has been tame, but it also depends on me and my life stage--how much of a risk it is right now.
Benz: It absolutely does. So, I would address this question based on life stage. For people who are in accumulation mode--certainly early accumulators--they don't have a lot of reason to be too worried about the impact of inflation on their portfolios. The key reason is that they are not yet spending those portfolios. And if they have ample equity exposure within their portfolios, that is the asset class that, over time, will tend to outrun inflation--and over long periods of time, probably by a decent margin. So, if they have ample equity exposure in their portfolio, that's one key reason not to worry. The other key reason is that the money that they are spending is coming from salary, and that over time, under normal circumstances, will typically be sort of an inflation-protected salary. So, they will receive periodic cost-of-living increases as part of that salary. So, younger accumulators don't have to worry too much about adding explicit inflation protection. That ample equity exposure is probably inflation protection enough.
Stipp: What if I'm someone who is close to retirement or in retirement? It seems inflation, given the kind of investment mix that I have, would be a bigger concern.
Benz: Here is where inflation protection does become more important--for folks who are in retirement or getting ready to retire. The reason they want to be more attuned to the risk of inflation is that at some point--or currently--they will be spending from that portfolio, and if they don't take steps to inflation-protect that income stream that they are drawing from that portfolio, certainly if they are just owning nominal bonds, that purchasing power from that income stream will be eaten away over time.
So, they need to lay in explicit inflation hedges. The best way to do that is to look at some sort of inflation-protected bond, whether it's I-Bonds, which you can buy directly from Treasury.gov, or some sort of a TIPS--Treasury Inflation-Protected Securities--fund is another way to do it. The idea there is that either the income you receive, in the case of an I-Bond, or the principal value of the bond, in the case of a TIPS bond, is adjusted to keep pace with inflation. This category, in general, has not been too attractive to investors recently, as we discussed; but I think, for investors looking to add TIPS exposure, it's arguably pretty cheap because TIPS are currently embedding pretty low expectations for inflation. So, if you buy a TIPS bond today, the inflation expectation that's embedded within it is roughly somewhere under 2%, currently. We know, historically, inflation has run hotter than that.
Stipp: And if I'm trying to figure out [whether or not] I have enough inflation protection, what's a good guideline for the amount of TIPS, perhaps, that I should have in a portfolio in retirement?
Benz: It will vary based on the investor; but looking at the data that our colleagues at Morningstar Ibbotson Associates put out, when they recommend TIPS allocations, typically somewhere in the neighborhood of 20% to 30% of the fixed-income portfolio would be earmarked for some sort of inflation-protected bond exposure.
Stipp: Of course, if you are in retirement, a lot of times you'll also be holding some equities for the out years of your retirement. That, as you said before, will also give you some inflation protection.
Benz: Perhaps some sort of a commodities-tracking product might make sense here, too. Again, I would keep it to a fairly small slice of the portfolio. When we look at the recommendations from Morningstar Ibbotson [Associates], it's typically in the neighborhood of 4% to 6% of the total portfolio. With precious-metals equities, it's debatable how great of an inflation hedge they've been historically, but there are some arguments for precious-metals equities also being good and cheap currently, as well. So, you might consider that a portion of your inflation hedge, too.
Stipp: Let's talk about a third big risk that you want to size up with respect to your portfolio. Somewhat related to inflation--they often go hand in hand--is interest-rate risk, the risk that rates might go up. It's something that we've been expecting but haven't seen yet, but maybe that's all the more reason to be aware of it now.
Benz: The Federal Reserve has telegraphed that it is likely to take some action on interest rates in 2015. But again, as you said, it's kind of a guessing game. We've seen a lot of even very high-profile professional investors opine that they think that rates are on the way up, and we really haven't seen that come to pass. So, I think you want to be careful about taking really drastic measures here to protect your portfolio against big interest-rate increases.
We've talked to a lot of investors, for example, who have just taken their whole bond allocation and moved it cash, and that seemed like maybe a good short-term move; but a few years later, we've seen a pretty good rally in bonds, so that probably wasn't a great decision. So, I think investors should avoid those either-or decisions. I do think, though, if you have fixed-income exposure in your portfolio, you probably do want to avoid long-term bonds, particularly given the very strong rally that we've seen over the past year. For people who have fixed-income exposure, probably short- and intermediate-term exposure makes more sense than venturing into long-term bonds, given how low yields are for those bonds now.
Stipp: What's a good way for me to assess what kind of exposure I have to interest-rate risk or rates going up? How can I stress-test it?
Benz: We've talked about what's called a duration stress test that was shared with us by Vanguard's Ken Volpert. What that means is that you are looking for the duration of a bond fund that you might own and you are also looking for the SEC yield--the Securities and Exchange Commission yield--which is a current snapshot of the investment's yield. So, you are subtracting that SEC yield from duration; the amount that's left over is the rough amount that you might see that particular fund lose in a one-year period in which interest rates rose by one percentage point. It's a very rough rule of thumb; investors shouldn't expect to use it with any degree of precision. But it can get you in the right ballpark or at least get you prepared for the types of losses that you might see for various product types.
When you look at, say, a long-term bond fund today, some of them may have durations of 14 or 15 years and their yields, in many cases, are well under 4%. That's a 10-percentage-point loss in that one-year period in which rates go up by one percentage point. That is a big rate shock; but nonetheless, that would be a sizable loss--perhaps more than that bond investor would have bargained for. It's also worth noting that this duration stress test is really only going to be helpful in so far as you are looking at high-quality bond types. It's going to be less useful for lower-quality bond types that really aren't responsive to what's going on in the Treasury market.
Stipp: Christine, sizing up the risk--a key part of your portfolio checkup. Thanks for helping us with those tips today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
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