Christine Benz's Tips for Turbulent Markets

Jason Stipp: I'm Jason Stipp for Morningstar. Unfortunately, there's no shortage of wildcards in the market as we head to 2012's final days. So it's reasonable to expect we may see some volatility.

Here to help us weather that bumpy ride is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: Before we talk about some tips for preparing for volatility--not sure if we'll see it or not, but it's likely--we've actually had a decent year in the market this year. Despite all these uncertainties, Europe and the fiscal cliff, stocks have done pretty well so far.

Benz: I think that context is really important. If, in fact, we do see more volatility, just remember that if you had a balanced portfolio, you probably have very strong returns from the stock component of that portfolio, and bonds have actually done quite well as well. So, investors who had balanced portfolios and weren't hunkered down entirely in cash probably are sitting on pretty nice gains. Even if we cede a few of those gains as this year winds down or into 2013, it's still not the end of the world. It's been a very good year.

Stipp: So we do have these headlines out there that indicate we could see a bumpy ride coming up. There are some things that need to get resolved. There are good practices for any kind of market. We don't know when volatility can heat up always, and one of them has to do with checking your asset allocation and especially the money that you'll need in the short term. If we weather a bumpy ride here, how can I make sure I'm ready?

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Benz: The key first step is to take stock of your near-term income needs. Especially if you are retired, this can be a particularly valuable exercise. So look at how much you have set aside in living expenses, how many months you could get yourself through. I usually recommend one to two years at a minimum. I know some planners have edged back a little bit on that, and have gone lower as yields have gone down on cash. But I think one year at a minimum, one to two years, maybe holding some sort of a cash/short-term bond hybrid. I think that's a good place to start.

And knowing that you have those income needs covered, you can rest easy knowing that you have at least that amount of time to watch your equity holdings recover. This, as I mentioned, is particularly important for retired people, but anyone who has near-term income needs coming up, maybe its next year's tuition bill or whatever it might be, just make sure that you've got that money protected, locked down, and you do not need to worry about it if in fact we have some equity volatility.

Stipp: So having a couple of years in those cash-like instruments, we know that markets can be really high for longer than expected, they can be depressed for longer than expected. That gives you some cushion there for markets to recover. You have those assets safe and sound or at least as safe as they can be in cash given the low yields.

Something else: You say it's important for investors to look at what they consider to be the safe portions of their portfolio, and the kinds of investments they have in those portions of the portfolio. What do you mean by that? How do we know if we're taking on too much risk in the safer assets?

Benz: That's a concern of mine right now, Jason, because we have seen these tremendous flows into some of the higher-yielding bond asset classes. My concern is that not only is money coming out of the sidelines, out of cash and into bonds, but it's also maybe chasing some of these higher yields and more equity-sensitive categories. So we've seen strong flows into high yield or junk bonds, emerging-markets bonds, bank-loan funds--those are all reasonable, aggressive kickers to a fixed-income portfolio, but they shouldn't supplant the safe piece.

So you want to make sure that you have your portfolio staged, not just with the cash to cover near-term income needs, but also your next-line reserves that you'll tap when that cash is depleted. That money should be in high-quality fixed-income holdings. Maybe you want to keep it a little bit short right now in terms of sticking with the short- and maybe intermediate-maturity bonds, not venturing into the long end. But you certainly don't want to have high yield and some of these other very aggressive categories being your next line reserves once your cash is depleted.

Stipp: So, we mentioned already that we've had a pretty good year for both stocks and bonds. Given that we could see some volatility coming up around the same time that I might be checking my portfolio and making adjustments, how should I think about that rebalancing process right now given the performance we've seen and the bumpiness we may see here in the last few days?

Benz: Well the good news is that the timing is right to actually make some changes or think about making changes. Certainly conducting a year-end portfolio review is something that I always recommend. So it's a great time, whether we have volatility or not, to get in there, look at your total portfolio's asset allocation, use our X-Ray tool to drill into your holdings and see what your overall asset class exposure is like--compare it to your targets.

So, if you have an investment policy statement, you've probably laid out a target range for your equity weighting, for your bond weighting, and so forth. Compare your current weightings to that target positioning, and see how you are doing.

I think once investors run those numbers, given how good bonds have been and how good stocks have been, they may find that really not a lot of repositioning is in order, but it's still worth running the numbers and going through that exercise.

Stipp: If you're going to be making those adjustments anyway, it's a good time to do them, given that we may have a little patch here where the markets get somewhat frenetic.

You mentioned, Christine, checking the overall potential risk that you have, but at times of volatility, you want to prepare for them, but they can also be times of opportunity. How should investors keep that in mind?

Benz: That's absolutely true. So, to the extent that you have long-term assets in your portfolio, especially stocks, make sure that you are using that value-oriented mindset so you are able to take advantage of potential sell-offs in the market. If you have a good value-oriented stock-picker running one or more of your funds, that's a great start, Morningstar's equity research is also very valuation sensitive. I think they've found the market to be generally pretty fairly valued currently, but they can certainly spot more opportunities in a market that's trending down. So, if you do have long-term assets, plan to be opportunistic and look at potential sell-offs as a buying opportunity.

Stipp: Lastly, when the market does have a sell-off for some reason, it's easy to feel out of control, it's easy to panic. We're all human. We all feel this way. But you say there are certain things that we can control as investors, and it's important to keep those things in mind on those days where you really feel out of control. What are some of those?

Benz: Well, the asset allocation piece, which we talked about, is certainly a key one. You also want to make sure that you are not paying any more for your investments than you absolutely need to. We've had price wars going on in exchange-traded fund land for the past couple of years. It's a great opportunity for investors to make sure that they are not paying more than they need to, whether they own index or actively managed funds.

Tax efficiency is also another category that falls at least somewhat within our sphere of control. I know everything feels very uncertain with potential tax hikes looming in 2013, but you can still pick through your portfolio, see if you can take advantage of tax-loss selling to find losses that you can use to offset capital gains, or ordinary income if you've cycled through all your capital gains.

People are also talking about tax-gain harvesting, given that capital gains rates are set to head up in 2013. I think that can be an attractive strategy. You can take tax-loss sales and actually use those to offset any tax gains that you are harvesting.

Look at IRA conversions, converting traditional IRA assets to Roth IRA status. The more we look at this host of tax-related hikes that are set to go into effect next year, the more anything Roth looks attractive. But I would say check with a tax advisor to help you run the numbers on whether that's a good strategy for you.

Maxing out tax-sheltered accounts as the year winds down is also another great strategy, because again with tax hikes potentially looming, tax-advantaged or tax-sheltered vehicles are going to make even more sense than they do today, and they make a lot of sense today.

Stipp: Well, Christine, we hope that we don't see too much volatility here in the last days of 2012, but these tips will help us at least have a nice benchmark to hold onto if we do get that turbulence. Thanks for joining me today.

Benz: Thank you, Jason.

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