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A Quick Read on Your Asset Allocation

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

Your asset allocation is perhaps the biggest determinant of your longer-term investment returns, but this is also an area where it can be hard to find some good information.

Morningstar's Christine Benz is here today with some quick-and-dirty tips for how to get a read on your existing portfolio's asset allocation, or to set a blueprint for an allocation on a new portfolio.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So you have an array of a few tools that you can look at for a back-of-the-envelope take on your asset allocation. The first one is a set of indexes that Morningstar has. Can you tell us little bit about how those are formulated, and how they might help?

Benz: Sure, these are Lifetime Allocation Indexes and Morningstar originally created these as in an effort to provide benchmarking tools for target-date funds, so they were created in conjunction with Ibbotson Associates, which is part of Morningstar, and arguably the leading name in asset allocation, and they use Ibbotson's human capital model to arrive at target allocations for investors with various retirement dates. And there are conservative, moderate, and aggressive flavors. So I rely on these benchmarks a lot when talking about asset allocation, I think they are really useful starting point.

Stipp: So can you explain a little bit about what you mean by the human capital and what that translates to as far as allocations over time for people in different age bands?

Benz: Sure. So the basic idea is that we all, when we begin working, have a lot of human capital, meaning that we can rely on a steady stream of income over many years, hopefully. But as we grow older and certainly, as we retire, that human capital becomes a less important part of our earnings picture, and we need to rely on our financial portfolios and our financial assets to step up and make up the difference.

So the idea is that a person's human capital is quite bond-heavy initially, meaning that it will send you a stable stream of payments throughout your life, and as you get older, it becomes more equity heavy and your portfolio needs to become more conservative, your financial portfolio.

Stipp: So Morningstar Allocation Index is a good place to start for a general sense. You also mentioned that these indexes had been created as a benchmark for target-date funds. Now these funds have become increasingly popular as a one-stop shop for investors, but you don't necessarily have to invest in a target-date funds to get some good use out of them.

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Benz: That's right. I think they provide really good intelligence about what some of the top financial firms are doing and recommending in terms of investor asset allocation.

A lot of advisors will say, "Oh, these target date funds are one size fits none. They are really not customized in any way." And I think that's valid criticism, but I think they are a good starting point for asset allocation, because their whole topic tends to be so shrouded in mystery. They are good place to begin.

Stipp: So do you have any favorite target-date lineups that you would recommend as a place to start for investors to look at the allocations in those funds?

Benz: A couple of I would mention, Jason: We think Vanguard's is great. I tend to think of it as a fairly plain-vanilla asset allocation mix there, moderate to slightly conservative.

T. Rowe Price's is another very good asset allocation mix, but it's much more equity heavy, and T. Rowe's thinking on that issue is that investors don't pay a heck of a lot of attention to their 401(k) assets. They see them steadily going up over a period of years, so they can tolerate fairly high equity positions, but you just want to bear that in mind that T. Rowe's is more equity heavy than most.

Stipp: So investors can go into, find the target date retirement year on those two fund families, for example, and check Morningstar's quote page for those allocations.

Benz: Right, exactly.

Stipp: So you mentioned that these are target date retirement funds, is there a way that I could use them for other purposes? So, for example, if I know I want to buy maybe a second home in 10 years, could I look at a target date 2020 fund for an idea of allocation I should have for that purpose?

Benz: Well, I would say no. It's probably better than nothing, but the key difference, Jason, is with a retirement portfolio, these aren't built with an idea that you will suddenly deplete it in the year that you retire. So they don't get all that conservative, and in fact, most of them and rightly so, hold a fair amount of equities even for people who are getting ready to retire.

Whereas if you do need your cash for that second home, you need it at all once, you're not going to have it dribbled out to you over a period of years; you need that money, and you need to have it battened down in very conservative investments at the time when you need it.

Stipp: True. A point you mentioned earlier about how some advisors will talk about how these things really need to be personalized or customized. If I was putting my portfolio together myself, what are the factors might I need to consider as I'm setting my allocation, even if I use target date funds or these indexes as a benchmark?

Benz: A couple of the key ones would be whether you're expecting other steady sources of income during retirement. In that case, you can tolerate a relatively equity-heavier portfolio than someone who is not going to be relying on those sources of income. So the thinking is that you will have some of that bond-type income coming into your house whether it's through a pension or maybe a part-time job or something like that. Whereas someone who is not going to be working or having a pension will want to make sure that they have a good amount of fairly conservative investments.

Stipp: Another thing that some investors may use in retirement are annuities; they are often not, or I don't know if they are found at all in target date funds. How should you think about an annuity also in combination with your asset allocation?

Benz: That's a great point and certainly there is a lot of data pointing to annuities being a very additive portion of retirement portfolios. That would argue, if you do have an annuity as part of your investment mix or as part of your portfolio, you'd want to think of that as the conservative bond-type sleeve, or maybe a portion of that component, and so the rest of your investment portfolio could be a touch more aggressive than someone who does not have that annuity.

Stipp: So if I wanted to check up, if I have an existing portfolio, or if I wanted to check my portfolio to see where it comes in line with some of these benchmarks, what tools on Morningstar could I use for my own portfolio, or if I wanted to test some investments in the portfolio?

Benz: Well, a couple of key tools I would point to. First is our X-Ray tool is a great way to get a sense of where you are currently, your starting point. So if you've got a portfolio already on the site, you can just click the X-Ray tab, or if you don't have a portfolio, you can enter it into that instant X-Ray tool, see your current allocation.

So if you want to see how your current asset allocation looks relative to what you're hoping to do with your portfolio, you can turn to our Premium Asset Allocator tool and that will show you whether your current asset mix puts you on track to either arrive at a lump sum payment that you're hoping to put your hands on during retirement or whether it can support a stream of income that you're looking for during retirement. So those were a couple of good tools right on the site.

Stipp: Great, Christine, thanks for pointing us in the right direction and for the tips on asset allocation.

Benz: Thank you, Jason.

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