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Benz: A Second-Quarter Portfolio Checkup in 4 Steps

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar. As the second quarter comes to a somewhat rocky close, investors may begin to anticipate their quarterly statements.

Here to offer a preview of what you may expect in that statement and also some tips for your quarterly portfolio check-in is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, it's great to be here.

Step 1: Assess Your Asset Allocation
You have a few steps here for a portfolio checkup, specifically for this quarter that's coming to a close now. Your first one is to assess your asset allocation, and you're paying attention at this point right now to stocks versus bonds. Stocks have been a little bit rocky in the second quarter, but year-to-date they've still done pretty well.

Benz: They have. So you want to do that X-ray with your portfolio using our X-Ray tool, plug your portfolio in and see how it's apportioned among the major asset classes. Chances are, if you've done nothing to rebalance your portfolio in the past few years, you probably are heavy on stocks relative to your targets--particularly if part of your goal is to reduce your equity exposure as you get close to retirement.

So in that case you do need to de-risk that portfolio, think about taking money out of stocks. My advice, though, if you are dramatically underweight bonds at this juncture, is to maybe think about pulling that money into cash, and then deploying it in a dollar-cost averaging program into bonds over a period of months. That way you can gain a variety of bond market environments, rather than putting all the money to work in a very volatile market.

Stipp: So you bring up bonds, and this is something that we've seen, a lot of investors worrying about in recent times. When you open that second-quarter statement, you're likely to see losses in your bond fund, which is something investors haven't seen for a while. What should I make of that?

Benz: Well, we've seen very broad-based weakness in bonds, really across categories, but definitely longer duration bonds have suffered some of the biggest losses; high-yield bonds have also had very large losses over the past couple of months. Emerging-markets bonds are another category that have had very big losses.

So you will, in fact, see some red ink and that may be somewhat unfamiliar. So I think that the risk is that investors might be inclined to completely get out of bonds. I don't think that that's warranted. In fact, I recently was talking to our colleague Eric Jacobson about what's next for bonds. He says that one thing he is hearing from a lot of bond fund managers is that, in fact, Treasury yields could be kind of topping out here at least for the near-term, or maybe the intermediate-term--that yields may not climb a lot higher. So the worst could, in fact, be over for general bonds and bond funds.

So, I don't think you want to sell out of bonds entirely. But again, if you find yourself dramatically light on bonds, I would probably just take that money out of stocks, move it into cash, and then dollar-cost average.

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Step 2: Revisit Sector, Style, and Geographic Exposure
OK. So step two for a portfolio checkup: revisit sector and style and geographic exposures. So, when I'm doing that and looking at my holdings, what should I compare them to?

Benz: I think you can start with the global market capitalization as kind of a proxy for what your portfolio might look like at. I often use Vanguard's Total World Market Index; the ticker is VT. Looking at the style and geographic exposure is a good starting point when benchmarking your portfolio. So when you think about the Style Box exposure there, you've got 25% in each of the large-cap squares, about 6% or 7% in the mid-cap squares, and 2% or 3% in that bottom row in each of those small-cap squares; that's Style Box exposure.

In terms of global exposure, younger investors might want to think about having a portfolio that approximates the global market capitalization. So, right now you've got about 52% in foreign stocks, about 48% U.S. I think that's a good starting point for people who are in their 20s, 30s, maybe early 40s. But you probably want to back off that foreign-market exposure as you get nearer to retirement, because you want to reduce those currency fluctuations in your portfolio.

I think you also want to think about your emerging-markets versus developed-markets allocation. So right now the ratio is about 10% emerging to 90% developed. I think that's a good benchmark for investors as well. Younger investors, again, might want to think about having a little more in emerging, but it's just a good way to think about where you're making your bets. If you are making bets that vary significantly from that global market cap, you want to make sure that you are comfortable with them, and you know that they are there.

Stipp: The point on emerging markets, I think, is timely one because we've seen weakness and concerns about emerging markets after a long period, where there was a lot of enthusiasm about emerging markets. If I look like I don't have as much exposure as maybe as I'd like to have, what should I think about all those concerns right now? Should I stay out of emerging markets because of those concerns?

Benz: One thing that Bill Bernstein, the famous asset allocator, once said has really stuck with me is, he said the beautiful thing about emerging markets is that periodically they get very, very cheap. So I think that that's a realistic possibility: as pessimism over China's growth and other issues in emerging markets become more persistent, the markets could in fact be very, very attractive. Again, that could be an opportunity for investors who are looking for places where there could be significant upside. Generally speaking, you are better off investing where valuations are nice and low, versus where there's a lot of euphoria about future growth in those markets.

Step 3: Check Progress Toward 401(k), IRA Contribution Limits
So, we've covered the investments in my portfolio. You also say it's good to check the types of accounts you have and your progress toward hitting your contribution limits for 2013.

Benz: That's right. So, one of the best ways you can seize control in a really difficult market environment like the one we've had in the past couple of months is by upping your contributions to your account. So, one thing to keep in mind is that in 2013, we've seen increases in the amount that you can put into 401(k)s and IRAs. So for 401(k)s, the contribution limit for people under 50 is now $17,500. It's gone up to $23,000 for people over 50. IRA contribution limits have also gone up this year to $5,500, and $6,500 for people over 50.

So, if you are not on track to hitting those maximum contributions, you want to see if you can nudge up your contributions. I think it's also important, as you're doing that, keep your eye on maintaining some taxable holdings as well, because there has been a lot of research that has really shown that there is a strong benefit to having taxable holdings when you come into retirement. You'll have some flexibility to keep your tax bracket down if you're not having to extract money from tax-deferred accounts like IRAs and 401(k)s during retirement.

Stipp: And you would say maybe even have taxable even if I'm not maxing out my tax-deferred accounts?

Benz: I think that's right. So there are certainly some very valuable benefits that go along with investing in tax-deferred and Roth accounts. But again, I think you do pick up some flexibility by having those taxable holdings as well. One piece of flexibility that you get with them is that, if you do need to tap your money prior to retirement, you can certainly do so with a lot [less] strings attached than tapping those other types of accounts.

Step 4: Be Opportunistic When Deploying New Assets
Christine, the last step you have is that you can be opportunistic if you do have new assets to deploy or if you're moving some money around. There is some opportunity. Although the market generally looks fairly valued, you can find some places to put your money in and maybe get somewhat of a bargain at this point.

Benz: I think that's right. So our equity analysts periodically look at what are the most undervalued sectors. Right now I think they're shining the light on basic material stocks, as well as the energy sector. Obviously, [those are] very cyclical parts of the market, but I think the stocks are cheap enough that there is a pretty good margin of safety there.

If you're not an individual stock-picker, you might think about just making sure that you've got that value column of the Style Box covered in some fashion. So maybe you have mutual funds that you're using value strategies. Those are the types of investors you want working on your behalf in a market environment like the current one. You want someone who will be intrepid, who will be looking at opportunities in emerging markets or in cyclical sectors or whatever it might be.

And I wouldn't just limit the opportunism to the equity markets. I would also make sure that you have a good flexible bond manager working on your behalf as well. So, one fund that we often recommend for that very aggressive slice of an investor's bond portfolio is a fund like Loomis Sayles Bond--a very flexible, very aggressive fund, often with very equity-like performance, but again, one that is really looking for sectors that are unduly beaten down and doing it very well over the years.

Stipp: Christine, the market has [given us] some thrills and spills recently, but it's always great to get your insights. These are great tips for doing that second-quarter portfolio checkup.

Benz: Thanks, Jason.

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