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5 Lessons From Portfolio Makeover Week

Here are some key takeaways from this year's series of portfolio checkups.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Morningstar.com is wrapping up its annual Portfolio Makeover Week. Joining me to share some key takeaways from this year's crop of makeovers is Christine Benz, who spearheads the series each year. She is Morningstar's director of personal finance and retirement planning.

Christine, thanks for being here today.

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

Dziubinski: You've been doing these portfolio makeovers for more than a decade now. And you've noted over time that one of the key reasons or key motivators behind people reaching out to you is to help them suss out their retirement readiness. A lot of these folks are on the precipice and not quite sure if they should pull the trigger and make the move. How do you help people sort out figuring out if they're ready to retire?

Benz: You're so right, Susan. We've had a great market, so we've had even more people who are in sort of that 55 to age 67 sort of band looking for another set of eyes on their plans. If I'm working with someone who is at that life stage, we start by asking them to take stock of what their income needs will be in retirement, what changes they expect to make between now and retirement, and how that will affect their budget. So, that's the starting point. Then, we look at what other nonportfolio sources of income they'll be bringing into retirement. Oftentimes, it's Social Security. Sometimes, it's a pension. We take stock of those, kind of reflect on the decision-making around the timing of those decisions. And once we've decided or determined how much of the income needs are coming from those nonportfolio sources, then we take a look at the portfolio. We look at whether it's sufficient to supply those additional cash flow needs in addition to the ones that are coming from Social Security or a pension. So, that's the starting point, just sort of checking the durability of the plan.

From there, we can do some work on the portfolio itself, where we look at whether the portfolio is set up to provide those cash flows. We all know that income has dropped through the floor over the past several decades. So, we need to look at sourcing those cash flows a little bit differently. That's where the bucket approach that I often talk about comes into play, where we set up some safe assets to provide cash flow if the early years of retirement happened to not be great for the equity market. We want to batten down the hatches. So, that's the general process. It's something that I find myself repeating again and again when I'm working with and talking with people who are at this life stage.

Dziubinski: Another common goal that people seem to have when they reach out to you for a portfolio makeover is this idea of, "Geez, my portfolio has just gotten kind of unwieldy. How can I streamline, how can I reduce my number of holdings?" Why is streamlining so important, and what are some things that we as investors can do to sort of figure out is my portfolio maybe a little unwieldy itself, and what can I do to sort of slim that down? 

Benz: Right. Frequently, that is the impetus for someone seeking portfolio makeovers. Oftentimes, the person doesn't suggest it, but I look at the portfolio and say, my gosh, we need to do some streamlining here. And the reason it's so important is that if you have fewer moving parts in your portfolio, you have an easier time monitoring it. You have an easier time knowing what your asset allocation is. You have an easier time keeping up with the holdings just to make sure that they're positioned the way that you want them to be. So, life is just so much simpler if you can reduce the number of moving parts in the portfolio. I tackle this from a few different levels.

One is whether we can look at collapsing the number of accounts. So, our great example in this year's portfolio makeover series was with a person who was getting quite close to retirement, and he was older than age 59 and a half. So, he had the opportunity to take his 401(k) holdings and merge them into his traditional IRA holdings. That's not an opportunity for everyone. But for him, it was very effective. So, we look at opportunities like that. And then, from there, once we've consolidated the accounts to the extent that we can, we can then look at the holdings within those accounts. I find myself again and again reaching for total market index funds, total market ETFs, whether equity or fixed income, can give someone such a worthwhile and effective building block for a portfolio. I've used target-date funds within portfolios. For example, there's a couple in this year's portfolio makeover series who were in their 40s. I think he was in his early 50s, several years until retirement. They had a number of accounts, but for both of them actually I saw the target-date fund serving a worthwhile role within their 401(k)s. They could concentrate on managing discrete building blocks within some of the other accounts, but the target-date funds were really good quality ones and served that role very nicely. So, I would urge anyone who is watching this to be thinking about streamlining, because it does help improve a portfolio so much.

Dziubinski: Another issue that comes up when you're conducting your portfolio makeovers involves tax efficiency. Let's talk a little bit about some of the tax mistakes that people perhaps tend to make that you've seen in some of these portfolio makeovers. And then, the flip side of that, what are some good tax strategies that people can pursue that might improve their portfolio's tax efficiency but won't trigger a huge tax bill to get to that more tax-efficient place?

Benz: That's a really important set of questions. Tax efficiency is so important, and I think investors sometimes underplay it. But a couple of the mistakes that I would observe would be people underutilizing tax-sheltered receptacles that are available to them. So, certainly, there are reasons to save in taxable accounts sometimes, especially if you have liquid needs, if you expect that you'll need your money anytime soon and don't want to be bound by the strictures of a 401(k) or an IRA. But making sure that they're maxing out those tax-sheltered vehicles is job one. And then, oftentimes, I observe asset location problems where maybe you've got a good investment, but you've got it in the wrong account. So, an example from this year's series was a high-dividend-yielding equity fund. Superb holding. I just wouldn't hold it inside of a taxable account. I would rather see that inside of an IRA, for example. Similarly, one of the portfolios had a municipal-bond fund inside an IRA. Not typically something I would do. Great fund, worthwhile for that person to hold, but it was better siloed within the taxable account. So, those were some mistakes.

In terms of addressing issues like that, it's tricky, because oftentimes the holdings that you'd want to extricate from the taxable account have appreciated themselves. And so, getting them into a better account might necessitate a tax bill. And that's also been exacerbated by the fact that we've had this really great equity market. We've had strong performance across the board. So, almost everything has a gain in it. I would urge investors to approach making their portfolios more tax-efficient with caution.

Dziubinski: Now, you alluded to the, in general, the great stock market that we've had for quite a long time, particularly here in the U.S. You've also seen in some of your portfolio makeovers that in large part because of the rally in the U.S. stock market a lot of investors are perhaps lighter on international stocks than they perhaps should be. How should we be thinking about international stocks?

Benz: Every single portfolio makeover that I worked on this series was, in my view, too light on non-U.S. equities. And, of course, we've been beating this drum that valuations are more attractive overseas than in the U.S. for a couple of years now, and yet the U.S. market has continued to outperform. But I do think that if investors want to try to set themselves up for better returns going forward, like over the next decade, I think it makes sense to emphasize foreign stocks to some extent. For most of the portfolios that I worked on, I targeted kind of a 2-to-1 ratio of U.S. equity relative to non-U.S. equity. I think that's a good starting point. When you look at a lot of professional asset-allocation frameworks, they're in that approximate ballpark. So, I think that as investors think about their portfolios, really no matter what their life stage, kind of think about that ratio as sort of a baseline when deciding how much they have in non-U.S.

Dziubinski: And then, lastly, another common ailment that you seem to see in portfolios quite a bit is that people hold too much cash. And you've observed that cash isn't as innocuous as it once was. What do you mean by that?

Benz: Right. A few years ago, I think I might have been more inclined to let someone's cash holdings ride a little bit. I would have been less worried about them. The thing that's bothering me right now, though, is inflation. That when someone has some sort of cash account--and in some cases, people had large cash hordes of a couple of hundred thousand dollars or more--the risk is that inflation is going to eat away at the purchasing power of that investment account that isn't really invested in anything that's earning much of a return. So, I do feel some pull to get these portfolios as fully invested as makes sense given someone's anticipated cash flow needs. Certainly, for younger folks, I think it makes sense to just go ahead and get asset allocated based on whatever framework you're using. If someone is getting close to retirement, I think they should have some cash at the ready in their portfolios, but they certainly wouldn't want to hold like five years' worth of liquid reserves. So, there I think you can safely get that money invested in short-term high-quality bonds. You do have a little principal-related volatility or the potential for it in such investments, but it won't be extreme provided you choose carefully. So, I definitely did observe that the cash holdings are creeping up. I think that relates to the strong market. People feel like, well, it's not a great time. I think you just have to figure out what your asset allocation is and deploy according to that framework that you've set out.

Dziubinski: Well, Christine, thank you so much for doing these portfolio makeovers. We know they are a lot of work, but not only is it a great service to the people you're doing the makeovers for, but it's a great service for the rest of us, because every year you come back and you're able to share these findings with us and give us all some tips on how to do our own makeover. So, we appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.