Tune Up Your Portfolio in Uncertain Times

The portfolio tuneup information shown in the webcast is available for download. Disclosure information is available at the end of the broadcast.

Christine Benz:

Hi, I'm Christine Benz, director of personal finance and retirement planning for Morningstar. Over the course of this presentation, I'll be talking about how to tune up your portfolio in uncertain times. We have had a bit of market volatility recently. We still have a pandemic raging. Inflation is on the front burner. And the Federal Reserve has indicated that it's planning to raise interest rates in 2022, possibly several times over. All of that has spooked bonds, and it's also spooked stocks a bit, and it may be spooking you as an investor.

I'll be talking about how to look over your portfolio today and how to make changes potentially in relation to your portfolio and your plan in the context of your own risk capacity and your own risk tolerance as well as your own goals. We will make these slides available to you on Morningstar.com. If you're the type of person who likes to take notes, you don't need to do that.

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I've organized this presentation into two major segments. The first segment discusses recent market actions, specifically how stocks and bonds performed in 2021. Then I'll get into a nine-step portfolio tune-up, and you can refer to that as you're thinking about reviewing your portfolio as 2022 kicks off.

So, let's start with the first slide, which presents a really long view of market action. This looks at stock and bond and commodities performance over the past 15 years. And what you can see is that things move around quite a bit. This is a little bit of a data dump, and it might be small on your screen. But I'll just talk about some of the key things that jump out at me as I look on this slide.

One is that you see a lot of blue at the top. Blue is U.S. large-cap and small-cap stocks. If you've been an investor in the equity market, you know that the U.S. market has been very, very good for quite a long time. And so, we do see U.S. stocks outperforming most other asset classes, certainly over the past decade. We also see that sometimes it's darkest before the dawn. So, you sometimes see periods where some of the orange spots, those are bonds, have struggled--where they're sort of at the bottom of the heap. So, I would point out 2017 into 2018, for example, where you see orange at the bottom in 2017, and then jumping to the top in 2018. The market's often like that, where the asset class that has been on the bottom jumps to the top in a subsequent year. We saw that in 2021 with commodities, which had been real laggards in the market for a long period of time. They enjoyed a period of really great performance in the second half of 2021 as investors began to be concerned about inflation. We saw commodities really spike in price. So, we typically see these rotations in terms of market sentiment. And my bias is to stay humble in the face of all this. Don't try to predict the future but instead understand that the best way to create a plan, to create a portfolio that will be durable in the face of an inevitable market volatility is to diversify across asset classes.

So, looking at stock performance in 2021, one thing we saw was that large-cap stocks generally outperformed small. This is part of a longer-term market trend where we've seen very strong performance from the biggest constituents in the U.S. market and relatively less strong performance from small- and mid-cap names.

Another thing we saw in 2021 was a real bifurcation between value and growth stocks. Value stocks staged a tremendous recovery after sort of a long period of slumbering relative to U.S. growth stocks. This was something that we saw across the market-capitalization spectrum. Small-cap value, in fact--even though small stocks in general weren't great performers--small-cap value was the strongest-performing square of the U.S. style box last year. So, if you had kept the faith in small-value stocks, that was vindicated in 2021, where we saw very strong performance from them relative to other parts of the style box.

We also saw persistence in this trend of U.S. stocks outperforming non-U.S. stocks. Across quarters in 2021, we saw better performance from U.S. stocks relative to developed-markets or emerging-markets non-U.S. stocks. This is part of a long-running pattern. And this is one reason why as you investigate your portfolio today, I would say examining your portfolio's exposure in U.S. stocks relative to non-U.S. stocks is a key thing to be looking at.

Moving over to bonds, we saw a bit of a fallback in terms of bond performance in 2021. This was ushered in by the Fed indicating that it planned to lift interest rates in 2022. We saw the bond market react preemptively, and we saw high-quality bonds experience small losses in 2021. Some of those have carried over into 2022. So, high-quality bonds tend to be the most sensitive to interest-rate changes or anticipated interest-rate changes. And we saw some of that action on display last year. We also saw lower-quality bonds, higher-yielding bonds perform relatively better. And the reason is intuitive, in that lower-quality bond issuers are often pretty sensitive to what's going on in the economy, and in those environments when the Fed is raising interest rates, because the economy is strong, because inflation is running up a little bit, those are environments when these issuers tend to be experiencing good business conditions, and that tends to be good for lower-quality credits. So, we saw lower-quality bonds--whether junk bonds or multisector bonds or bank-loan investments--enjoy pretty strong gains in 2021 despite the threat of interest-rate changes.

A related phenomenon, though, is that we've seen yield differentials between lower-quality bonds and higher-quality bonds really shrink during this period. I sometimes joke that every rock has been turned over in search of yield, because income is just so scant these days. And that's certainly a phenomenon that we've seen play out in the bond market, where the yield differential on higher-quality and lower-quality bonds is really quite low today. In fact, it's lower than it was before the pandemic started. So, that indicates that investors are feeling pretty optimistic about lower-quality bond issuers' prospects. But I think it also urges circumspection on the part of investors in these bonds, because you're really arguably not getting paid a lot more to be invested in lower-quality bonds than you are in higher-quality bonds. The margin for error just is pretty, pretty slim today. So, that's something to keep in mind if you have lower-quality bonds as a part of your portfolio. You don't need to throw them overboard, but I do think it's important to remember what role they play in a portfolio, which is more as sort of an aggressive kicker for your fixed-income exposure as opposed to a substitute for high-quality fixed-income exposure.

So, looking at all of this, I think that it would argue for some caution in terms of how investors are thinking about their portfolios today. We've seen a long run of tremendous equity market performance. We've also seen a long run of pretty decent bond market performance, last year notwithstanding. So that has many market forecasters, when they're called upon to forecast what the stock and bond markets might return over the next decade, that has many of these folks calling for fairly muted returns, at least on U.S. stocks and on U.S. high-quality bonds.

This is a slide that I grabbed from my colleagues in Morningstar Investment Management. They periodically put out these capital markets assumptions. And what you can see is a very low return expectation for U.S. stocks, just 1.6%, and a similar return expectation for U.S. bonds. And they arrive at these forecasts by looking at a couple of different things. So, for stocks, they're looking at their expectation of earnings growth, they're looking at where dividend yields are, and they're looking at their expectation of price multiple contraction or expansion. Because U.S. equity market valuations are still pretty high, they're thinking that the U.S. market valuation, U.S. multiples, will probably contract over the next decade. That's one reason why those return expectations are so muted. For fixed income, the prediction is fairly straightforward. Starting bond yields are a pretty good predictor of what you're apt to earn from the bond market over the next decade. We're low today in terms of fixed-income yields. And so, that depresses the return prospects for fixed-income assets. These figures are not inflation-adjusted, so it's important to factor that in as well. So, if we have even a normal inflation rate over the next decade, that means that the investor in a 60/40 U.S. portfolio will probably be sort of flatlining over the next decade.

If there's a good news story here, I would say it's that our team is expecting relatively better results from non-U.S. stocks, especially emerging-markets stocks but also developed-markets stocks, over the next decade. So, that's another potential catalyst for reviewing your U.S. versus non-U.S. exposure, especially if you've been practicing a policy of benign neglect--it's potentially worth revisiting those exposures.

I would also urge you to check out my compendium of capital markets forecasts. This is something I put together at the beginning of every year. I recently put one out for 2022. It incorporates what our Morningstar Investment Management team is thinking, but it also incorporates outside firms' capital markets forecasts, because I do think it's helpful to get an array of opinions on this. I would note that our Morningstar team tends to be sort of toward the low end of return forecasts, especially for U.S. stocks. I would say there's more commonality in terms of the forecasts when it comes to fixed-income assets, in part because the relationship between starting yields and returns is so straightforward. But I would survey those forecasts to just get your arms around what these firms are thinking in terms of what you might expect various asset classes to return. To affirm, I would say that they're all forecasting better returns from non-U.S. stocks relative to U.S. stocks over the next decade, and that owes largely to lower starting valuations on non-U.S. stocks today.

Now, let's talk about the tune-up portion of the presentation. I'll just quickly run through what I hope to cover in this nine-step portfolio tune-up. We'll start with what I call a "wellness check." We'll move on to discuss asset allocation, which will be the next most important determinant of how your portfolio behaves after your savings rate and after your withdrawal rate if you're retired. We'll talk about how to evaluate your portfolio's liquidity, how much cash you should have on hand. With inflation ticking up a little bit, obviously, having too much in cash is a risk factor, but we'll talk about how to rightsize your cash exposures. We'll talk a little bit about how to assess your equity exposure. So, within your equity portfolio, how to gauge the appropriateness of your style box exposure and your U.S. versus non-U.S. exposure. I'll talk a little bit about fixed income and specifically how to evaluate your portfolio's interest-rate sensitivity. Because inflation is top of mind, I'll spend a little bit of time talking about how to evaluate how inflation-tough your plan is and how inflation-tough your portfolio is. I'll spend a little bit of time talking about how to use Morningstar tools to evaluate your holdings in your portfolio. And finally, we'll come away with a little bit of an action plan. And we'll talk about how to make changes to your portfolio in a tax-efficient way.

A couple of notes on portfolio checkups, portfolio tune-ups, whatever you want to call them. First, I would say that less is more. So, while I'm a fan of investors periodically checking up on their portfolios, my view is that once or twice a year is plenty for most investors. I think a policy of benign neglect generally beats one that's too active and busy and hands-on. So, try to resist the urge to be a tinkerer with your portfolio. Another thing I would note is that it helps to keep focus. And that's what I've tried to do by organizing this into specific steps. Because it can be easy to kind of meander around as you review your portfolio. My goal of breaking this into nine steps is to keep the whole thing on track. I also think it helps to progress from most important jobs to maybe those that are less mission-critical. And that's why I've organized this presentation as an inverted pyramid with the important stuff on top and then the less important stuff generally at the base of the pyramid, and we'll tackle those items toward the end. I think it's also important as you tune up your portfolio to think about your plan and your long-term strategy and keep those top of mind when you decide whether any changes are in order. And finally, I mentioned the importance of bearing in mind tax and transaction costs as you go about your portfolio tune-up. And I'll talk a little bit about how to be tax-efficient, specifically, as you tune up your portfolio toward the end of the presentation.

So, the first step in the process is to ask and answer the question: How am I doing? And as I mentioned, this really depends on your life stage, the way that you would go about making this evaluation. If you're someone who is still accumulating assets for retirement, still working, the key things you want to look at would be your savings rate over the past year. Many people have in their minds that 10% is adequate. Actually, I think for many households, that's probably too low, that if possible, setting the bar at 15%, or even higher if you're part of a higher-income household, is a really worthy goal. So, look back on how much you've managed to save over the past couple of years and see whether you are in line with where you're hoping to be. But review your savings rate, see if you're on track. Also look at how much you've managed to save so far. So, we've had very strong market performance, but investors might be hard-pressed to know whether they have saved enough so far. I would refer you to these benchmarks that Fidelity Investments periodically puts out that helps investors gauge the adequacy of their nest eggs based on their life stage. So, Fidelity's benchmark for someone who's aged 35 is that having saved 2 times your salary at that life stage is a worthy target. By the time someone is age 45, the target is 4 times salary; at age 55, the target is 7 times salary; and then at age 65, the target is aged 10 to 11 times salary. These aren't perfect benchmarks. In fact, my colleague, Amy Arnott did a deep dive on how investors might think about these benchmarks in the context of their own situations. But nonetheless, I think they're decent starting points for deciding whether you have saved enough or whether you potentially need to kick up your savings rate even more. I would also say for folks who are getting close to retirement, you can start thinking about withdrawal rates and the sustainability of whatever your withdrawal rate might be as a lens to decide whether you've managed to amass enough in savings.

I think it also helps for people at this life stage to use some kind of a retirement calculator to see whether their plan is on track. So, a couple of calculators that I like are Vanguard's retirement nest egg calculator. I also have long recommended T. Rowe Price's retirement-income calculator. Whatever calculator you use, I think ideally, you would use a calculator that is somewhat holistic, that's taking into account your tax situation, that's taking into account all of your assets for a given goal, so your spouse's assets, your own assets, your nonretirement assets that you might bring into retirement, your nonportfolio sources of income, so Social Security will be an income-producer for many of us in retirement. So, you want to find a holistic tool. You also want to find a tool that's using what I consider realistic return assumptions. So, if you're looking at a tool that's assuming 10% equity market returns over the next decade, I think that's probably a little bit too aggressive. So, you'd want to take a look at what sort of return expectations the calculator is embedding and use that when deciding whether a tool is in the right ballpark in terms of your overall plan.

If you're in retirement, I think you want to come at this question of how you're doing in a little bit different way. And the key gauge of your plan's wellness, of your portfolio's wellness, is your spending rate in retirement. So, if you're looking at your spending rate, you want to start with your total spending and subtract out any nonportfolio income sources that you have. So, if you have Social Security, for example, that's supplying a portion of your spending, you'll subtract that out. The amount that's left over is your portfolio spending. You'll then divide that amount. So, assuming you've come up with an annual portfolio expenditure, you'll then divide that amount by your total portfolio to come up with what your withdrawal rate is. And then, you want to look at whether that is a sustainable withdrawal rate. Many investors are familiar with what's called the

4% guideline

for retirement spending. I think that's still a decent starting point for thinking about your plan. The basic idea is that 4% guideline assumes that someone wants a more or less fixed withdrawal when adjusted for inflation in retirement. So, if someone has a $1 million portfolio, that means he or she could take $40,000 in year one of retirement and then just inflation-adjust that dollar amount thereafter. That's the basic system underpinning the 4% guideline. So, to use a simple example, if someone were taking 4% of an $800,000 portfolio, that would translate into a $32,000 withdrawal in year one of retirement, then if inflation runs at 3% in the next year, you'd give yourself a little bit of a raise to account for that inflation. So, you'd be up near $33,000 in year two.

We recently did some work on this topic of sustainable withdrawal rates at Morningstar. One thing we came away with was the idea that new retirees especially might want to be a little bit conservative with respect to their withdrawal rates. So, they might want to think about starting withdrawals in the low to mid 3% range, assuming that they have a balanced portfolio, a 30-year time horizon, and want a 90% degree of certainty of not outliving their assets. That situation may or may not match your own portfolio parameters, your own plan parameters. Certainly, for people who have been retired for 15 years don't need to be that conservative. They can certainly take more of their portfolios because their life expectancies are shorter. So, if you're someone who's 75, and you're looking at this, you don't necessarily want to assume a 30-year time horizon. So, in our research, which we've made available and discussed at length on Morningstar.com, we've talked about how asset allocation and how time horizon figure into this, and the print I'm afraid on this slide is quite small, but I'll walk you through some of the overarching takeaways.

One is that if you have a longer time horizon than 30 years, so if you have a 40-year time horizon, if you're a very young retiree, you'd want to be more cautious still than that mid to low 3% range. You'd want to be probably under 3% with a balanced portfolio. On the other hand, the person who has a 20-year time horizon in retirement could reasonably take closer to 4%, or possibly even over 4%, possibly closer to 5%. So, time horizon matters a lot in all of this. One thing I would call out, though, is that swinging for the fences in terms of higher equity exposure really didn't move the needle in our research. So, even though equities have had a higher return than bonds, historically, and certainly, over the past 10 and 15 years, the issue with ramping up equity exposure to 80% or 90% is that the portfolio courts more sequence-of-return risk. That means that the portfolio, the person who's just embarking on retirement, could encounter a weak market environment and that would mean that he or she is pulling from depreciating equity assets. And that's not something that you'd want. You'd want to be able to draw upon cash and bonds rather than your equities at such a juncture. And that's the risk that having too much in equities sets you up for.

So, moving over to talk about asset allocation. This is the next key step in the process to look at your portfolio's personal asset allocation. A tool I have often enthused about for checking your portfolio's asset allocation is our X-Ray functionality on Morningstar.com. So, if you have a portfolio saved on Morningstar.com, you can click on the X-Ray tab to review your portfolio's X-ray. There's also a tool called Instant X-Ray that you can find on Morningstar.com where you can add in your portfolio's holdings and you can see your portfolio's total allocation. So, if you go through that process, you'll see a screen that looks like this one that has your asset allocation, arrayed in a pie chart, which is what you see at the top left.

The cool thing about X-Ray is that it shows you your portfolio's actual asset class exposures. So, if you have mutual funds in your portfolio and actively managed mutual funds in your portfolio, it will drill into those portfolios and apportion your total asset class exposure accordingly. So, if you have an international fund, for example, that holds some U.S. stocks, that will count toward your U.S. weighting. If you have a large-value fund that also holds some large-blend stocks or some mid-value stocks, it will show up in terms of your style box exposure. So, X-Ray is a good way to get your arms around your portfolio's actual asset class exposures. That's the starting point for this exercise.

The next step is to compare that asset allocation to your target allocation. And at this stage, I think many investors might say, "Wait a minute, I don't have a target." And that's totally fine. I think the key is to get your arms around something reasonable in terms of evaluating your portfolio's asset class exposures. So, a really quick and dirty way to do this would be to look at a good target-date fund geared toward someone in your age band. So, if you think you'll retire in 2040, for example, look at some of the target-date 2040 funds. We also have Morningstar Lifetime Allocation Indexes, which I often refer to, you can see aggressive, moderate, and conservative flavors of those indexes. I think those are another lens for gauging your portfolio's asset class exposures just to see whether you're on track.

The issue with asset class exposures and targets for them is that it's really tough to come up with one-size-fits-all asset allocations. It depends on a lot of things. So, it depends on your human capital, so your proximity to needing your money, certainly, but also just the volatility of that capital. So, if you're someone who is a commission-based salesperson, for example, you may have periods where you're relatively flush, but you might also have periods where your income isn't as strong. That argues for being a little bit more conservative in terms of your asset allocation. You also want to think about all of your assets, so not just your personal retirement assets, but if you and your spouse will be embarking on retirement together and drawing upon the same portfolio. Looking at all of those assets together, I think, is a good way to gauge asset allocation. But those are some rough measures that you can use to evaluate the appropriateness of your asset allocation given your situation.

So, as investors review their asset-allocation exposures, one thing that might jump out at you is that you may be fairly far off from whatever targets you've laid out for yourself. I think a good rule of thumb to bear in mind is that you want to rebalance your portfolio's exposures if you've drifted 5 or 10 percentage points from your target allocations. So, a portfolio that was 60% equity/40% bond five years ago would now be over 70% equity and roughly 30% bond. So, that hands-off portfolio has probably gotten more aggressive for many investors. Similarly, a portfolio that has not been rebalanced between international and U.S. would have seen its U.S. component drift higher. And then, we talked about how value stocks had a really great run in 2021. That was a relatively new phenomenon. We've seen growth stocks really outperform value by a big margin over the past five years. So, that's another part of your portfolio's exposure to take a closer look at, whether you should rebalance from growth into value because hands-off has probably made your portfolio heavier on stocks, heavier on U.S. stocks, and heavier on growth stocks if you haven't done anything to it.

If you're someone who is using the bucket system for your portfolio, and this is especially relevant for people who are retired and who are in drawdown mode, I think the Bucket approach can be a helpful way to gauge the appropriateness of your current asset-allocation mix. So, in my basic Bucket setup, I've set aside two years' worth of portfolio withdrawals in cash, so not taking any risks, not taking any chances with this portion of the portfolio. Bucket 2 is accounting for another five to eight years' worth of portfolio withdrawals. That's taking a little bit more risk with that portion of the portfolio but not too much. So, that portion of the portfolio is generally anchored in high-quality short- and intermediate-term bonds, bond funds. You might have a little bit of Treasury Inflation-Protected Securities exposure in this portfolio. You might have a dash of equities exposure. So, with those two buckets, you're accounting for 10 years' worth of portfolio withdrawals roughly, eight to 10 years, and that means that if Armageddon occurs in the stock market, you would be able to essentially spend through that safe portion of the portfolio without having to touch the equity assets, and that's especially important if the market continues to encounter volatility. You'd want to ensure that your plan is set up so you're not having to touch depreciated equity assets. And then, assets for years 10 and beyond of your portfolio withdrawals, I think can safely be parked in a globally diversified portfolio of equities. But this is the basic Bucket setup. I think it's helpful to use as kind of a sniff test on the viability of whatever your asset allocation looks like today.

If we wanted to translate that Bucket system into an actual model portfolio--and I have lots of different variations of these model portfolios on Morningstar.com--that would start out with Bucket 1, which would include two years' worth of portfolio withdrawals. So, assuming that we're taking $60,000 out of the portfolio per year, I'd have $120,000 in cash investments. And then, another eight years' worth of portfolio withdrawals, so $480,000 of the portfolio would be in that generally high-quality, fixed-income portfolio. And then, finally, the Bucket 3 is the long-term growth engine of the portfolio. That's generally a globally diversified equity portfolio. And here's where I would park a little bit of--if I wanted to use some of the higher-yielding fixed-income types, I'd stash them in this portion of the portfolio where I had a nice, long time horizon for them. So, I think this framework can be helpful as you think about the appropriateness of your retirement plan. Even if you're not using a Bucket strategy, I think it can be a helpful check on whatever your asset allocation is.

The next step in the process is to evaluate the adequacy of liquid reserves. So, of your cash assets, the baseline for people who are working is three to six months' worth of assets set aside in liquid reserves. I think sometimes people are put off by how high those numbers seem--that that seems like a lot of cash. And I think the issue is that you really want to think about how much you could get by on in a pinch, rather than thinking about how much you're spending today while you're employed. The idea is that you're building yourself an emergency cushion of the expenses that would be absolutely essential if for whatever reason you were not able to earn an income or if you were to become disabled, the idea is that you're building yourself an emergency buffer. For people who are retired, I like the idea of holding one to two years' of living expenses in cash investments. If you wanted to run with a lower cushion, you could potentially take that down to six months' worth of living expenses. But I think you would want to probably be a little closer to the one to two years' worth of living expenses.

A couple things to think about with respect to liquid reserves. One is that if you've gone through this X-Ray process, you'll probably see that your cash weighting is higher than you thought it was. And that's especially true if you have active mutual funds in your portfolio. You don't want to take those residual cash balances into account when tallying up your emergency cushion. And the key reason is that you can't call your mutual fund and say, "Oh, equity fund, I would just like to pull out my cash holdings." It doesn't work that way, unfortunately. So, you'd want to look at the amount that you have that's truly liquid. And then, I think even though cash yields are very, very low today, it's also worthwhile just shopping around to make sure that you're getting the highest yield that you possibly can. And specifically, I think you want to be careful about some of the notoriously low-yielding cash accounts that are available, brokerage sweep accounts, for example. Even though they might be convenient, they're typically very low-yielding. So, if you are a little bit thoughtful and willing to do a little bit of homework, you can probably pick up a higher yield on your cash securities.

One thing that often comes up for retirees who want to maintain that cash cushion on an ongoing basis is, where to go for that cash, how to replenish that Bucket 1 or those cash reserves as they become depleted. So, if you're spending from that cash bucket on an ongoing basis, how to top it back up. And I think that there are a couple of ways to go about doing that. One is to simply take any organically generated income distributions, whether from your bond holdings or from your dividend-paying equities, and have those sent over into your cash account. That way your cash account is kind of topping itself up on an ongoing basis. So, even if you're not reaching for income, looking for income-rich stocks and bonds, you can still enjoy a little bit of income coming in the door through those income-producing securities. And then, if you need additional cash reserves, and many investors certainly will, because income is really low today, you can then use rebalancing annually to help top up the cash reserves. So, you would pull from the very appreciated portions of your portfolio and use them to top up your cash holdings. For investors who are looking back on 2021, which was generally another great year for the stock market, pulling from appreciated U.S. equity holdings seems like a really logical place to start if you need to rebalance and you need to top up your cash holdings.

The next step in the process is to assess your equity exposures. So, we've talked about some of the tailwinds that U.S. large-growth stocks have had. If you look at your portfolio's style box exposure, and you've been hands off with your portfolio, if you haven't been periodically stripping back U.S. growth stocks, it's a good bet that your portfolio is skewing toward U.S. versus foreign, it's skewing toward growth versus value. And so, you may need to do a little bit of repositioning to help restore balance. It may be that you have as an ongoing bias a bias toward U.S. large cap growth stocks, that that's your choice. But it's just important to be conscious of whatever biases you have in your portfolio. If you're seeking balance, if you're anticipating reversion to the mean, anticipating that growth stocks may cede ground to value and that U.S. stocks may cede ground to non-U.S. over the next decade, doing a little bit of repositioning there probably makes sense.

So, on this slide, I've got an indication of the extent to which U.S. growth stocks have outperformed value. They've nearly doubled value over the past five years. U.S. stocks relative to non-U.S. stocks have also trumped non-U.S. stocks. So, those are areas to think about doing some repositioning, especially if you're kind of looking forward as opposed to using the rearview mirror to drive the car.

Thinking in terms of your portfolio's fixed-income exposures, the Fed's planned interest-rate hike has certainly put pressure on bond prices that started in late 2021, and that is certainly persisted into the early innings of 2022. We've seen some losses on bond funds just recently. So, for the year to date, we've seen the biggest losses in terms of long-term bonds. They tend to be the most interest-rate-sensitive. We've also seen some weakness in emerging-markets bonds recently where they have fallen back just as much as long-term bonds. So, I think the thing to remember is that even though the Fed has not taken action to lift interest rates yet in 2022, that investors in the bond market are often preemptive. So, bond prices tend to factor in the market action. So, we've seen bond prices take a little bit of a hit. I think it's important to review your portfolio's interest-rate sensitivity. Most investors don't own long-term bonds as a portion of their portfolios. But it is important to understand the price effects that your portfolio might encounter during a period of rising interest rates.

So, I often like to point investors to what I call a

duration stress test.

And to do this, you don't need to be a bond market geek. But you need to find a couple of data points about the funds in your portfolio. So, you'd find the duration of a bond fund in your portfolio, and you can find that on the Portfolio tab of Morningstar.com. Find

duration

and then also find a statistic called

SEC yield

, which you'll be able to find for ETFs, exchange-traded funds, on Morningstar.com. For mutual funds, you'd want to look on your fund company's website for SEC yield. And the SEC yield is just a current snapshot of the fund's yield. And so, you're taking those two numbers and you're subtracting that yield from the duration and the duration is a measure of interest-rate sensitivity. And the amount that you're left over with is the amount that you might expect to see that bond fund lose in a one-year period in which interest rates jumped up by 1 percentage point. So, that's a big jump up in terms of interest rates. But run your portfolio holdings through that sort of stress test. So, if you have a long-term bond in your portfolio, a long-term bond fund in your portfolio, you'll see a duration of roughly 18 years today, certainly a high double-digit duration today, and you'll probably see a yield in the neighborhood of 2% today. So, running through that little bit of math, you'll see that that's a fairly significant loss in that one-year period in which we would see a sizable interest-rate jump of 1 percentage point.

Most investors don't own long-term bonds specifically for this reason for their potential volatility. Most investors own shorter-term and intermediate-term bonds, which tend to be much less interest-rate-sensitive. So, looking at intermediate-term bond funds today, we see durations oftentimes in the neighborhood of six or seven years. Yields are pretty low. So, yields don't provide too much of a cushion. But nonetheless, that leaves you with, I think, a little bit of comfort in terms of thinking about, well, how vulnerable are my fixed-income holdings in a potentially catastrophic interest-rate increase. It's probably something that you could live with. But nonetheless, run your holdings through this stress test. This will tend to be most useful if you have high-quality bond funds in your portfolio. It will be less instructive if you have lower-quality bonds.

While you're looking at your portfolio's fixed-income exposures, it's also worthwhile to evaluate the role of lower-quality bonds. I mentioned that lower-quality bonds had been pretty resilient during this recent market sell-off. The issue to keep in mind is just how these bonds tend to perform in varying market environments. So, one thing we know when we look at the data is that lower-quality bonds are much more correlated to stocks than they are to high-quality bonds. And so, I think that can help you figure out how to use them in your portfolio. I like them as a portion of the equity exposure in a portfolio rather than thinking about them as higher-yielding alternatives to high-quality bonds. High-quality bonds will tend to deliver ballast for your portfolio. So, they're what you want to hold if you want a portion of your portfolio that will potentially gain a little bit when stocks go down. Low-quality bonds will not do that for you. They will typically move in sympathy with the equity market. Even though they might not lose as much as stocks in market sell-off, they will tend to behave in sympathy with equities, which is one reason why I like investors thinking about them as part of their long-term portion of their portfolio. If you're a bucket investor, for example, you'd think about holding them in Bucket 3 in that long-term piece.

The next step in the process is to evaluate inflation protection, so to think about how insulated your plan is from inflation. And I think that this is certainly top of mind for investors right now. We've seen the most recent inflation reading at 7%, its highest rate in decades. And this necessarily has a lot of consumers, not just investors, has a lot of consumers spooked about what this means for their plans. I would say that inflation tends to be most worrisome for retirees. For workers, workers right now are in a really strong job market. Many employers are making workers whole in terms of inflation, where they're giving out nice raises, they're giving out cost of living increases. Retired workers who are pulling part of their cash flows from their portfolios, I think necessarily are more concerned because the portion of their portfolios that they're withdrawing to cover their living expenses aren't inherently inflation-protected. So, I think that they have reason to feel a little bit more cautious during this period.

I do think it's important to think about your own situation, to think about your own income sources when deciding how worried to be about inflation. So, if you're a worker, if you're getting strong increases in terms of your paycheck, then you're relatively insulated from inflation. Your cost of living increases may not be entirely keeping up with inflation, and that's something to think about. But nonetheless, over time, we do tend to see salaries keep up at least on some level with inflation. On the other hand, people who are pulling withdrawals from their portfolio, that's the group who I think needs to be the most cautious. And so, you'd want to be especially cautious if you are someone who is pulling your withdrawals from your portfolio and a healthy share of that portfolio is parked in fixed-rate investments that don't necessarily keep pace with inflation. So, the most vulnerable of all would be the person who is relying on his or her portfolio for a big share of his or her income needs, and that portfolio is parked in very safe assets. So, it's parked in CDs, it's parked in nominal bonds. That's a person who would need to be more cautious and more thoughtful about making sure that they're putting in inflation protection for that plan.

So, how do we make sure that our plans, that our portfolios, have inflation protection? I think you want to look to a couple of key assets. At the top of the list for people who are in drawdown mode, so for retirees, that would call for having a healthy allocation to what are called

inflation-protected bonds.

These are bonds where you receive a little bit of a nudge up to account for inflation. And so, Treasury Inflation-Protected Securities are a variety of inflation-protected bonds. I-bonds are another variety of inflation-protected bonds. If you're someone who is in retirement and you have fixed-rate investments in your portfolio, I would augment them with a component of inflation-protected bonds.

Another way to protect against inflation, to defend against inflation over time, is to make sure that our portfolios have ample stock exposure. I always caution people that stocks are by no means an inflation hedge. So, if inflation goes up 7% this year, we won't necessarily see stocks go up 7% this year. But one thing we know is that over long periods of time, stocks do tend to outearn inflation, which is one reason why it makes sense even for retirees, even for older retirees, I think it makes sense to hold a healthy sleeve of equities in their portfolios. And certainly, for younger investors, one of the main ways you defend against inflation is by asking for those cost of living increases and then within your portfolio maintaining ample stock exposure.

There are other, what I would consider, sort of, niche ways to obtain inflation protection. So, you might look at real estate investments, either real estate investment trusts or direct real estate ownership. One thing we know about those assets is that when inflation is high, that's usually when landlords or real estate owners can push through increases. You might also look to a category like commodities. I have to say that I'm a little bit lukewarm on the category in part because investors have historically used commodities so poorly. They bought them at exactly the wrong times. But that's another category. When we look at the categories that tend to do hedge fairly well against inflation, commodities do a decent job.

On the bond side, we also see some inflation protection being conferred through categories like bank-loan or floating-rate investments. To a lesser extent, high-yield bonds also appear to be somewhat protective in an inflationary environment. And we were showing on earlier slides how high-yield bonds tend to be less vulnerable in the face of rising interest rates. That's often an inflationary environment. So, high-yield bonds tend to do relatively better in those environments. So, those are some categories to be thinking about as you evaluate your portfolio's protection against rising inflation.

Moving on to talk about individual positions, I won't spend a lot of time on this. I know that a lot of our Morningstar.com viewers and readers spend a lot of time thinking about their individual positions. But we certainly have a lot of good tools on Morningstar.com for reviewing individual positions. If you have mutual funds or exchange-traded funds, I think the medalist ratings are a quick way to see whether your holdings are best-of-breed within their categories. That's a great quick check on the quality of your holdings. If you see a lot of medalists, that's usually an indication that you've favored low-cost funds that probably will do well relative to their peers in the years ahead. If you're a stock investor, you can look at a few different criteria. You can look at fair value--price to fair values, you can look at star ratings for stocks. You can also look at moats as a way of evaluating business quality. Those are some quick ways to get your arms around the quality of the holdings in your portfolio. And you're really looking for diversity. But generally speaking, if you're tilting your portfolio and you want to set it up for good results in the future, tilting toward wider-moat companies, tilting toward those with lower price to fair values puts you in good stead for forward-looking return prospects.

So, what do we do with all of this? How do we create an action plan? I think it's important to approach this really getting back to your life stage. I would argue that if you've gone through this exercise, if you flagged some areas where perhaps you're taking too much risk in your portfolio, so if you found that your portfolio's equity allocation is really, really high, and you're planning to retire in the next couple of years, I would argue at that life stage de-risking that portfolio is imperative. On the other hand, if you are someone who was in your 30s or 40s, there's probably less of a need to de-risk in a really big way. You may want to make some changes around the margins. So, you might want to peel back from U.S. and put more and more money toward non-U.S. stocks. But it's a little less urgent if you are embarking on retirement in 20 years or more.

On the other hand, many people who are younger, who are saving for retirement are simultaneously saving for other goals. So, maybe it's a home down payment or some other goal that's closer at hand, de-risking those assets is mission critical. So, even if you have a long time horizon to retirement, if you have other things that you want to accomplish in the next five or 10 years or even fewer, de-risking that portion of the portfolio is really, really important. So, put that at the top of your list when it comes to deciding whether to take action.

The key issue is, if you've gone through this process, and you've determined that you need to make changes, it's important to watch out for transaction costs. So, although those are increasingly less of an issue, given that we've kind of moved into this no-transaction-cost environment, but a key thing to keep an eye on is tax costs that you might incur. And so, that's one reason why if you've gone through this process and you need to make some tweaks whether peeling back on U.S. stocks, or whatever the case might be, it's best to start that process within your tax-sheltered accounts, so within your IRAs and 401(k)s, other retirement plan assets. Start that process within those accounts, because you can do all of the tinkering that you want within those accounts without triggering any tax costs. If you're subject to required minimum distributions, so if you're over age 72, and you're subject to those RMDs, I think it makes all the sense in the world to annually pull those RMDs from the positions that you're most overweight in. So, if you need to make changes to your portfolio, and you're subject to RMDs, why not do both at the same time. So, for a lot of RMD-subjective investors, my view is that peeling back U.S. stocks, specifically U.S. growth stocks is probably a rich vein to mine if you're doing some rebalancing.

If you are moving on to your taxable accounts, so if you've done some repositioning within your tax-sheltered accounts, and you decide that your taxable accounts are too aggressive, or you want to make changes, a good thing to do to avoid triggering a tax bill is to potentially add new assets. So, if you're still adding to those accounts, to put the new additions to that portion of the portfolio into the underweight holdings. That's a tax-efficient way to rebalance your taxable accounts. You may or may not be able to get back to your target allocation using that strategy, but it does tend to be a good tax-efficient way to start, and it's certainly something that people who are adding to their portfolio should think about.

Other things to think about as 2022 grinds on. Certainly, think about higher contributions. If you've looked at your savings rate and you decide that you want to try to lift your savings rates in 2022, know that 401(k) contribution limits have increased a bit this year, HSA,

, contribution limits are lifting a little bit as well. IRA contribution limits are staying the same in 2022, so $6,000 if you're under 50, $7,000 if you're over 50. But revisit those contribution limits if you haven't done so recently. It's also worth noting that we still have this backdoor Roth maneuver that has been a little bit topical thing over the past year where we had potentially saw Congress acting to close that backdoor Roth loophole. It's still alive and well for 2022. So, I would say for investors who are higher-income investors who can't make direct Roth IRA contributions, that thinking about getting in through the backdoor is still a viable strategy. Certainly, check with your tax advisor to get his or her take on that. But I think that for many financial advisors who I talk to, they're still urging clients to go forward with those backdoor Roth contributions. For very high-income earners, backdoor Roth 401(k) contributions might make sense. It's a complicated topic that's beyond the scope of this discussion. But if you are in that very high-income band, if you're a super saver, ask your tax or financial advisor whether backdoor Roth 401(k) contributions might make sense to you.

And finally, I think it's worth assessing the appropriateness of IRA conversions really every year, but especially as retirement approaches. If you're someone who has saved primarily in the confines of tax-deferred accounts throughout your career, you may have an opportunity, especially as you move into retirement, to do some conversions at a relatively low income tax rate relative to where you may be later in retirement. Here's another spot to get some tax advice.

So, that concludes my presentation. I want to thank you all for your attention for spending time with you today. I want to thank you for your loyalty to Morningstar. And also note that these

for people who would like to do so later on. Thanks so much for watching.

I'm Christine Benz for Morningstar.