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Tune Up Your Portfolio in Uncertain Times

Here's how to strengthen your portfolio for the years ahead.

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. We'll have the slides available to you later on.

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.