Give Your Portfolio a Checkup

Portfolio Makeover Week
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The following is a replay from the 2013 Morningstar Individual Investor Conference.

Christine Benz: Welcome our next session of today’s conference. We will be talking about how to give your portfolio a checkup.

As in all of today’s sessions, we welcome your questions; if you would like to submit one, please click the Ask a Question link to the right of your viewer. If you would like to get a look at my slides and download my slides, we will be providing a link to download them, and that will appear in the chat window below your viewer.

Before we get started today, one question I often get about giving portfolio checkups is just how often you should be doing this. I talk to a lot of investors who probably overdo their portfolio checkups. They look at them on a weekly, monthly or even more frequent basis, and my advice is always that less is more when it comes to this sort of checkup. So, I think, semiannually or annually is plenty for most investors. If you are checking up a lot more than that you might be tempted to get in there and make changes, changes that might not be necessary, and in turn you might incur tax and transaction costs and you might be responding to short-term performance. So, I would say you would want to go through this sort of comprehensive checkup that I will discuss today just about once or twice a year, nothing more than that.

In this presentation today, I’ll run you through six key steps that I think investors should be taking as they’re thinking about reviewing their portfolios today. So, the first one would be just a basic wellness check. See how you’re doing relative to your goals, and I will split this checkup into two tracks; one for people who are in accumulation mode and the other for people who are in retirement.

The next step of the process is to review your portfolio's overall exposures, and I will talk about how you can use some Morningstar tools to do just that.

I will also talk about the importance of checking your liquid reserves, money that you need to have on hand to fund near-term living expenses or perhaps emergency expenses. So, I will share some benchmarks for your liquid reserves, how much you want to have in cash currently. I will then get into some quick rules of thumb for reviewing individual holdings, both mutual funds, as well as stocks and I'll share some things that I see as yellow or red flags that should jump out at you as you review individual holdings.

I'll also talk about some potential risk factors that loom for investors today, particularly in the realm of income-producing securities. We've seen a lot of interest in that area, but I think that there are some risks that perhaps some investors are underestimating. We'll talk about how to look at some of those risk factors in your portfolio.

And the last step in this process is doing an audit of the overall costs you're paying to keep your portfolio up and running. So, I'll talk about looking at your overall investment-related expenses in the portfolio, as well as your tax costs, and I'll discuss why I think that's so important.

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Step 1: Gauge Viability of Your Current Plan
So, let's get right into the first step. For people, who are in accumulation mode, even before you get into your holdings and start digging around in your portfolio, first take a step back and review how you're progressing toward your goal. So, assuming that you're saving for retirement there are couple of rules of thumb that I would share with you. One is, simply a savings target that you should shoot for, and this one comes courtesy of the Vanguard Group. They typically recommend that investors try to steer 12% to 15% of their incomes to savings per year. If you look back on the amount that you've been able to save and invest over the past year and you come and way under that threshold, it's a good time to see if you can find a way to potentially steer more money into your investments in the year ahead.

Another rule of thumb that you could use comes courtesy of my colleague, David Blanchett, and this is for people who are getting very close to retirement. So, they are still in accumulation mode, but they are kind of wondering will: "We have enough? Do we have enough?" So, a starting point and that's obviously a very important question, but a quick rule of thumb is simply to look at whether you have 25 times your income needs set aside in your investment portfolio for retirement. So, for example for someone who is targeting a $100,000 in income above and beyond what Social Security or a pension or other sources of income might provide, they would need to have using this rule of thumb $2.5 million set aside in their investment portfolio. It's a big number, but it's a way to see whether you're on track to actually retire.

I would also recommend that investors spend some time looking at some of the calculators that are available on the Web, and there are increasingly some very powerful tools for doing that. I have mentioned a couple that I like right here. T. Rowe Price Retirement Income Calculator is a tool that I’ve often liked because it's robust and it is comprehensive. Fidelity also has some good tools as do a lot of the other financial-services providers.

My advice is to sample in array of opinions to see if you are on track. You might tend to find a comforting convergence that you are getting some of the same feedback from these tools, but my advice is to try more than one. I would say as you look to some of these tools, you want to gravitate toward those tools that tend to be the most holistic. So, you want to make sure that they're considering taxes, the role of Social Security in your plan. You want to make sure that they are actually using realistic rates of returns for various asset classes in the future.

So, I know that there are some tools out there that use very rosy return expectations, especially for fixed income right now, and I think you want to play it conservative. So, if one of these tools is forecasting say a 6% fixed-income return, recognize that it is using pretty rosy assumptions in terms of its output.

And finally, you also want to make sure that your tool is factoring in the role of inflation because that can be such a powerful force, both in accumulation, but especially in your decumulation years. So, look for tools that are as holistic as possible. It may take you a little longer to enter your data, but ultimately, you'll have a better output. So, if it turns out that you are looking light in terms of your savings target, you want to focus first on making sure that to the extent that you possibly can, you are maximizing your contributions to tax-sheltered vehicles.

So in 2013, we've seen a little bit of a bump up in the allowable contributions to both 401(k)s and IRAs. So, in 2013, people under 50 will be able to contribute $17,500 to 401(k)s, 403(b)s or 457s. If you are over 50, you can contribute $23,000.

For IRAs we are also seeing a little bump up in allowable contributions. Those are going up to $5,500 for people under 50 and $6,500 if you are over 50. I would also note that we haven't yet hit April 15th, tax deadline day, so you still do have time to squeak in a contribution for the 2012 tax year. Just recognize that the limits were a little lower for 2012, they were $5,000 for people under 50 and $6,000 for people over 50. So if you are finding yourself light in terms of your overall retirement goal, plan to steer your contributions toward these tax-sheltered vehicles first before you consider investing in a taxable account.

The process is a little bit different for retirees in terms of this overall wellness-check idea. And I would say for retirees, they want to focus on one key metric, and that's their withdrawal rate. How much are they taking out of their portfolios currently?

This is such a huge topic that I think we can devote a whole session to it, but I think it's important to know first of all how you calculate your withdrawal rate. And what that simply means is that you look back on your portfolio withdrawals over the past year and you divide that by your investment balance that's left over; that is your withdrawal rate. And I'm going to share some very rough rules of thumb. Many retired investors might be familiar with what's called the 4% rule, that means that you withdraw 4% of your balance on day one of retirement and then you just gradually inflation adjust that number as the years go by. That 4% rule, it's widely cited in part because it was pretty well stress-tested.

So, Bill Bengen, who was the financial planner who originally developed the 4% rule, looked at a variety of market environments over many years and looked at what would be a safe amount to withdraw without running out of money. He homed in on this 4% rate, and I think it's still a reasonable one for investors to use as they think about what is a reasonable withdrawal. Anytime you're edging much higher than 4%, I think you need to be concerned. I think it's also important to recognize some of the assumptions that are built into that 4% rule.

Bill Bengen thought about a 30-year time horizon in retirement when developing that rule, and he also thought about a portfolio that was approximately 60% equity, 40% bond. So, if your retirement characteristics are much different from those assumptions that he used that would call for a slightly different percentage for you. I did want to mention also that there has been a little bit of research recently actually suggesting that perhaps the 4% rule is a little bit too aggressive.

Some of that research came from my colleague, David Blanchett, and a couple of other retirement researchers. Basically what they were looking at was the fact that fixed-income interest rates are so low currently. So, the raw materials for robust returns during retirement simply aren't what they once were. They suggested that actually a 3% rule of thumb is perhaps more in order, and I think that's particularly true for investors who are conservative or who have portfolios that are heavily skewed toward fixed-income assets.

In any case, I think that this withdrawal rate is well worth revisiting every year versus simply setting a target dollar amount and just blindly doing that inflation adjustment. I think it has kind of emerged as a best practice within the realm of portfolio withdrawals that you'd want to revisit that withdrawal rate annually, and think not just about how your investments have performed, but also think about your age, because age has a role in this, as well. So, certainly if you are an older retiree, someone in their 80s, you could arguably take a higher withdrawal rate than someone who is a younger retiree with a much longer time horizon.

So, a lot to think about here, but mainly you want to focus on what your withdrawal rate has been and does it come into this realm of what we think are sustainable withdrawal rates? If you're seeing a rate much higher than 4%, that's a red flag, and maybe a reason to look around and see if you can wring some cost savings out of your budget.

Step 2: Evaluate Portfolio Positioning
Once you get through that wellness check, which I think is a really important part of the process, the next step is to dig into your portfolio itself. And for this, I would recommend one of Morningstar's tools. I think it's one of the best features on our site, it's our X-Ray tool. And you do have access to X-Ray if you have a portfolio in our Portfolio Manager tool. You can just click on the X-Ray tab within Portfolio Manager to get the X-Ray view of your portfolio. If you haven't entered a portfolio on the site, you'll need to use our instant X-Ray tool which you can find on the Tools tab of Morningstar.com. And you simply need to come equipped with your holdings names or their tickers, as well as the amount you have within each holding. So, you need to find your most recent statements, or go online and get your current balance, and so armed with that you can enter your portfolio on Morningstar.com and then see the X-Ray.

Here's a screenshot of a sample X-Ray portfolio. You can see kind of a data dump here. There's a lot going on. But you can see an asset-allocation pie chart, so you can see how your portfolio shakes out among the major asset classes. You can also see an investment-style depiction for both stocks and bonds. The functionality in the stock piece is a little bit more robust, so I'll focus my attention there more. You can see your sector weightings as well relative to the S&P 500. Below that--it got cut off in the screenshot--is the geographic distribution of your portfolio. But I would say, as a starting point, focus your attention on that top part, on that top left-hand part, the asset-allocation pie chart, because this will be the most important determinant of how your portfolio behaves. So you want to take a look at your asset allocation and see how it compares relative with your targets.

I know at this point a lot of investors say, "Hang on a minute; I don't have targets." And that's OK. Morningstar has what are called Lifetime Allocation Indexes, which are time-horizon-based asset-allocation programs that do vary by risk tolerance. So, for example, if you're someone who plans to retire in 2035 and you've got a low risk tolerance, it will show you approximately how much you should have in the major asset classes based on that information. So, we do have an array of different asset-allocation ranges. You can use these to benchmark your portfolio's asset allocation. We'll be linking to a PDF in the chat window below your viewer to show you how you can see those asset-allocation parameters.

Another idea is to use a good target-date fund as a proxy for what you're trying to achieve. So, again, say you're trying to retire in 2035 and you want to look at what good funds that are geared toward people with the same time horizon look like, use a target-date fund to do that. So, a couple I would recommend, these are two of Morningstar's Gold-rated target-date series, both the target-date funds from T. Rowe Price and the ones from Vanguard I think are good ways to benchmark your portfolio’s asset allocation. A lot of research has gone into creating those portfolios' target allocations, and you can kind of see some variation. So you will see that T. Rowe's tend to be somewhat more aggressive; Vanguard's a little bit more middle-of-the-road. But in any case, I think they both provide reasonable benchmarks if you're looking for what an appropriate target-date fund would be for you and what an appropriate asset allocation would be for you.

I want to talk a little bit about if you determine that your portfolio is extremely light or heavy on one asset class or another. One common occurrence these days, even though we have had very strong equity market returns, is that people are finding that their portfolios are actually still light on stocks. Maybe they got defensive during the bear market and never quite got back in. So now, four years later, they are kind of looking at the fact that stocks have enjoyed a fairly steady runup over the past four years, and they're wondering what to do.

This is a really common conundrum, and to people in this position I would say, first of all, don't panic, because things aren't really as bad as you might think. When I look at the average price to fair value for all of the securities that Morningstar's equity analysts cover, you can see that it's trading right around 1.0, which means that the average stock is trading about in line with its fair value. That's not super encouraging, but nor should it be very, very discouraging either. So just keep that in mind that even though it's maybe not the best time to invest, it's not a terrible time either. So use that as a starting point.

Another thing you could think about is setting up a dollar-cost averaging program to remedy the fact that your portfolio is light on equities. So, you can plan to move the money into the market over a period of months or, if you're very light on equities, even over a period of a couple of years. One point I would make, too, even though I'm a strong believer in rebalancing, which means adding back to those asset classes where you tend to be light, I think you want to be careful and not rebalance too often. So, if you are seeing a divergence versus your target of maybe just a couple of percentage points, probably there is no need to take action. I think you do want to take action if, for example, your equity weighting is say 5 percentage points or more lower than your target; that's a place to get an action plan to increase your equity weighting.

So, in addition to thinking about dollar-cost averaging, another strategy to keep in mind is just making sure that you have a good value-oriented manager working for you. So, make sure that in your investment-style exposure, which I will cover in a second, that you do have good representation on that left-hand side of the style box. The beauty of having a value-oriented investment or two in your portfolio, or even more, is that you do have someone who is actively scouting for bargains as they put together the portfolio. So, I think that that can be a good strategy in the current environment if you find out that you are light on stocks.

Another idea for individual stock investors is to simply look at stocks within our coverage universe that have high star ratings, and in turn low price/fair value ratios. That can be a great starting point for your research. I often layer on a screen for narrow or wide moats to just ensure little bit of quality in the universe that I am screening. But I think that that price/fair value can be invaluable when you are scouting around for companies that still look very attractive after the runup that we've seen in stocks over the past four years.

Probably an even more vexing conundrum for investors right now is people who run through the asset-allocation review and find out that they are actually quite light on bonds relative to where they should be. I think that this is the case for a lot of people who are approaching retirement. They are hearing a lot of the headlines about bonds and hearing why they should be worried about bonds, and yet their portfolios are pretty heavy on stocks and light on bonds. What should they do?

First of all, I would say that if you are getting close to retirement, derisking is really the order of the day. It's something that you need to prioritize. So, for people in that situation, what I would recommend is doing that as soon as possible and not worrying so much about taking action at the wrong time. I think a way to think about doing that is potentially moving your money that you would have earmarked for bonds into cash, and then slowly dollar-cost averaging that into the bond market as yields go up and bonds potentially become more attractive. It doesn't seem like you would want to move a big slug of money into bonds at this particular time.

I also think you want to think about the overall, to the extent that you do have bonds in your portfolio or are adding bonds, it seems like you’d want to think about new additions being shorter in duration, meaning that they would be less interest-rate-sensitive, and also make sure that they are fairly high in terms of their overall credit profile. So those are two characteristics that I would prioritize if I were adding bonds to a portfolio at this juncture.

Another strategy that we just talked about in the previous session is delegating your bond portfolio, or a portion of it, to a truly active, flexible fund manager. So, a couple of the funds that Morningstar likes are Harbor Bond, which is a no-load clone of the big PIMCO Total Return Fund, or Metropolitan West Total Return Bond. Those are both funds with very flexible toolkits. They can be a nice choice in an environment like the current one, where there are a lot of uncertainties for bonds. They won't be miracle workers. They won't completely be able to skirt a nervous interest-rate environment, but they should hold up better than funds that are hewing to a more specific strategy, where they have to have a certain asset class composition or a certain duration.

The next step in this process is to take a look at your investment-style exposures. So, I provided a few benchmarks here that you can use. On the left is simply a view of the total stock market index and I used Vanguard's Total Stock Market Index as a proxy. You can see its investment-style exposure currently. So, you can see that it has the lion's share of assets up in the large-cap row, relatively less in mid-caps and less still in this small-cap row.

I think that this is instructive because it helps you see that the index actually hues heavily toward the largest-cap names. If your portfolio is significantly underweight those large-cap names that might be by design; you may want it that way because historically small- and mid-cap names have had better very long-range returns than large-caps, but you need to be aware of that style exposure.

The same is true on the value to blend to growth spectrum. You want to be aware of any intended or unintended bets that you might be making. I know a lot of investors specifically do favor that value column of the Morningstar Style Box and that's fine, but if you have a bet there that you didn't know that you're making, it may be time to think about changing things around a little bit, so you aren't making such a large bet on a given part of the style box.

In the right hand view what I did was find the median price/fair value ratios for all of the stocks in our coverage universe within each square of the style box. You will see that I did not have data for the small-cap row in part because we don't have enough small-caps under coverage; though we do have some, we don't have enough under coverage to formulate a price/fair value ratio for the whole universe. But you can see some intelligence from this graph on the right-hand side of your screen, basically you can see that value-oriented stocks look cheaper to us than growth at this juncture, and generally speaking the large-caps look relatively less expensive to us than mid-caps.

Again, we can't formulate an opinion about small-caps, but oftentimes we see things move in a fairly stair-step fashion. So, based on what you see in this grid, I think it's a good hunch that that small-growth square might be the most expensive of all in terms of its price/fair value ratio.

So, this is another piece of intelligence that you can use when you think about shaping your portfolio. I think arguably if you wanted to make a little bit of a tactical tilt in your portfolio given that the market is pretty fairly valued currently, you could think about emphasizing that large-cap value square in particular.

The next step is to think a little bit about the geographic positioning in your portfolio. Again, I've provided some benchmarks for you to use as you think about reviewing your geographic exposure. I've provided the allocations for the total market, the total global stock market between U.S. and foreign stocks as well as between developed and developing markets.

So you can see that in this particular measure, the U.S. is less than half of the global market capitalization. It's a rare U.S.-based investor who actually has this much in foreign stocks, but it's something to keep in mind as you review your portfolio's positioning. If you find that you have 80%, 90%, or close to a 100% of your portfolio in U.S. stocks, just recognize that you have a significant home-country bias in that portfolio.

Incidentally, our colleagues at Ibbotson Associates here at Morningstar have some opinions about how global portfolios should be, and their view is that that should kind of change based on age range. So accumulators should have more or less fully global portfolios. Specifically young accumulators should really think about mirroring this global market capitalization. But as you near retirement and enter retirement, you want to take off some of that foreign currency exposure, in part because you're usually getting some foreign currency risk that you may not need. So, that's just a general way to think about how your foreign allocation may evolve over time. You’d want to have relatively less in the portfolio as the years go by.

Also, as I noted, I provided the developed versus developing allocations for the global market cap currently, and you can see that developing economies even though they've been very much in the news and people are excited about their long-term prospects, still make up about 15% of the global market capitalization. A lot of investors may have significantly more than that, and that may again be by design, but just recognize that you typically have higher volatility with some of these emerging markets than you do in developed markets, though arguably in recent years developed markets have had some problems of their own.

Step 3: Check Liquid Reserves
Once you reviewed your overall portfolio’s exposure, the next step is to think about the adequacy of your liquid reserves in your portfolio. So, I've provided some very basic rules of thumb for both accumulators and retirees. So, people, who are still working, will want to think about having at three to six months' worth of living expenses stashed away in highly liquid accounts. This is virtually dead money. So, you have to make peace with that fact, but the idea is that this is money that will be stable and will be there if you need it.

So, I think that three to six months is a really good rule of thumb. I think it's important to take a step back before you get too daunted by what that number might look like. We are not talking about the money that you're spending currently. We are talking about the money you could get by on in a pinch, if you lost your job. So, chances are if you take a step back and think about what it would look like if you didn't have a house cleaner or didn't go out for lunch every day and strip back on some of those daily expenses, you might find a much smaller, more manageable, and less daunting number.

For people, who are retired, I think that they want to set the bar higher, in part, because they need that liquid reserve to fund their living expenses. So, I used to say you'd want to hold one to two years or even two years in highly liquid reserves. I think that what we've seen over the past several years is that the opportunity cost of having too much in cash is very, very high.

So, I would say at the low end, retirees would want to think about having six months' worth of cash and living expenses, at the high end, maybe two years, probably no more than that because of that opportunity cost.

But the idea there is, and I've talked a lot about this in some of my bucketing articles that I've done for Morningstar.com, the idea is that you're preserving your liquidity, you're keeping assets at the ready to meet your living expenses. And if you're doing that, if you have that bucket number 1, you're able to tolerate some volatility with your bond investments as well as your equity investments.

A couple of last points on the liquid reserves, if you've gone through that X-Ray process you've probably seen some cash there. Some of that may truly be your cash holdings, your money market accounts or whatever else you've put in there. Some of that cash may in fact be residual cash that your active fund managers hold. What you want to be careful about is not counting those managers' cash holdings toward your liquid reserves because you can't trade in a fund and say "Can you give me the cash piece of my investment back?" You have to sell the whole thing.

Any money that is residual cash in your funds should not count toward your liquid reserves. I would also not count any short-term bond holdings. Even though you might think of them as part of your liquid reserves, I'd probably want to keep them separate from your true cash holdings.

Step 4: Review Individual Holdings
So, once you've gone through that liquidity check, the next step is to review your individual holdings, and this part of the process can be as complicated or as simple as you like. I do think that Morningstar Analyst Reports provide a great way for people to quickly skim what's going on with their holdings, both their individual companies that they might own, as well as their mutual funds. It's a great way to conduct the due diligence process. But you can also do some of this work on your own. So, if you are looking for yellow or red flags in terms of your fund holdings, I would consider the following potential areas of further investigation.

First would certainly be any manager changes; any notable strategy changes would also be a cause for further research. So for example, if you had a fund that you bought to be your small-cap holding, but now you're seeing it's kind of covering the mid-cap part of the style box, it's a reason to get in there and look at "Has this process changed? Has maybe the fund grown, and the manager is having to do something different? Ask some questions about what's going on with the strategy.

You can also look at persistent underperformance. I always say that if you do own active funds in your portfolio, you really want to give them a pretty long leash, but say you've seen persistent underperformance versus an index or maybe a cheap index fund that you're using as a benchmark; that can be a red flag. So, one thing to think about is that we now have had a couple of market environments in short succession that allow funds to exhibit really different tendencies.

So, you want to see if you have an active fund, either it was great during the bear market or it has been great subsequently. If it has done neither for you, I think that that's a big red flag, and that's a reason to think about what's going on with this fund, and why can't it seem to shine in one market environment or another.

I think you also want to pay attention to the extent that you have funds to dramatically heavy individual sector or stock bets. Some investors might be perfectly comfortable with that. They might want their mangers to invest in their best ideas, regardless of how it affects the portfolio's overall positioning. But if you owned a fund because you thought it was low-risk and now you see dramatically large bets on stocks or sectors or whatever else it might be, you want to consider that a potential risk factor and do a little bit more research.

In terms of individual stock holdings, here again I would urge you to focus on the price/fair value ratio. I think that's a great guide to whether a company that you hold is potentially undervalued, fairly valued or overvalued; you want to do a little bit of a check up on that. And also one of the key things I pay attention to is the overall trend in moat. So if you are seeing a disintegrating moat, think about why that might be and think about does that change your thesis on that particular fund.

Step 5: Troubleshoot Potential Risk Factors
Now I'm just going to spend a little bit of time talking about troubleshooting potential risk factors in your portfolio. So I'll talk about a couple of specific areas. One is fixed income, where I think investors are rightly concerned about what the future holds, and yet we've seen a strong gravitational pull toward investors buying bonds. And then also I’d like to look a little bit at dividend payers, where potentially some investors are underestimating the risks of their holdings and underestimating the role of valuation when buying dividend payers.

So, first, just to highlight the fact that we've seen tremendous inflows into bond funds over the past several years. In 2012 alone, we saw more than $300 billion flow into various bond asset classes. Investors seem to be concerned, or maybe driving with a rearview mirror, concerned that they are going to incur 2008-style losses again. So they seem to be saying they'd rather have that safe, low, but knowable, return on bonds rather than risk losses in equities again. So this is worrisome to me in part because we have tended to see investors mistime their purchases and sales historically. Again, this chart is a big data dump, but I urge you to get in and look at it a little bit, and what it shows you is the average total returns for various asset classes. So these are the average funds within each asset class, their total return by time horizon, along with their, what we call, investor returns. To come up with investor returns, we take the total return, but we marry it with the cash flows into and out of a fund. So, to use a simple example, say, you had a fund that had 100% return in year one and 10% losses in years two and three. In that particular case, if all the investors arrived somewhere toward the tail end of year one, which is a typical pattern, the typical investor return will be much lower than the fund’s published total return for that three-year period because most investors didn't get that 100% gain. They got much less than that.

What we see is that, when we look at asset classes, when we look at categories, when we look at individual funds, we see a lot of mistiming. My concern is that investors who are buying bonds today may be coming to the party late. So, just a general caution about bonds at this juncture, given how low yields are, given the potential of rising interest rates.

A couple of the categories that we've seen receive very big inflows are also some of the riskier categories, some of the more credit-sensitive categories that do tend to have more equitylike characteristics. So, for investors who have been embracing these categories, I think they just want to go in with their eyes wide open to the risks that could lie in some of these portfolios. So, we've seen very robust flows into emerging-markets bonds as well as junk bonds. We've also seen yields compress. So, yields have come down quite a bit as assets have flown into these categories, and as performance has been pretty good. The bond prices have gone up; yields have come down. So, investors in these asset classes just don't have that yield cushion that they did even a few years ago. So that's a potential risk factor. To the extent that you're embracing such categories, make sure that you're holding them as sort of supporting players to the higher-quality portion of your fixed-income portfolio.

Just a couple of other categories where you have a similar phenomenon in play, so you've got some equity sensitivity in both bank-loan and multisector bond funds. I have provided here their 2008 losses for just a bit of context. I'm not suggesting we'll go back there anytime soon. But the idea is to show you that with some of these categories, you're getting investments that, in fact, perform somewhat between your stock and bond holdings. They are not necessarily giving you that diversification potential that high-quality bonds have. So, just mind the risks if you're looking at some of these categories right now.

I also wanted to talk about higher-quality bonds, they too carry risks at this juncture. I wanted to share a quickie duration stress test, which we talked about in the last session. Simply what that means is that you'll find the duration [a measure of interest-rate sensitivity] for a fund, which is available on Morningstar.com; find its SEC yield, which is now available on Morningstar.com; subtract the yield from the duration. That is roughly the amount that you could expect that fund to lose in a one-year period if interest rates jumped up by 1 percentage point. It's obviously a very rough rule of thumb, and you'd only want to think about it with your high-quality bond categories; it's less useful if you have junk bonds, international bonds, or other things in your portfolio.

But these are just a couple of examples of this duration stress test in action. So, you can see with the Barclays Aggregate Bond Index, you're looking at a loss of roughly 3%, 3.5% in that 1-percentage-point move in interest rates. And you can see if you take duration out and you venture into long-term bonds, you're looking at potentially much higher interest-rate sensitivity and, in fact, much higher potential losses. So, just be mindful of that.

Here is a quick shot of the dividend-paying sectors that we have under coverage, and what I wanted to show here is that, even though I love dividend payers as much as the next person, it's important to really pay attention to valuations if you're embracing dividend payers at this juncture. I can't help but notice that some of the categories, some of the sectors that have the highest price/fair value ratios based on our analyst coverage do land in the traditional dividend-paying sector. So, consumer defensive, REITs, utilities, all have historically been dividend-rich sectors, but we have seen price/fair value ratios go up quite a bit over the past couple of years along with the popularity of those areas. So, pay keen attention to the price/fair value ratio. If you're investing in a fund, just make sure that the manager is using some sort of a valuation emphasis as he or she puts together the portfolio.

Step 6: Conduct a Cost, Tax-Cost Audit
I just wanted to talk about conducting a quick cost audit, including tax costs, of your portfolio. You want think about a couple of different things. One is that if you have X-Rayed your portfolio, you can see the average expense ratio for that total portfolio, and I would take that number and compare it with a good target-date fund geared toward someone in your age band. So, I’ve provided here Morningstar's two favorite target-date funds and their expense ratios for the 2025 vehicles. What you can see is 0.73% for T. Rowe and a much lower percentage rate for Vanguard, in part because it is all index funds, so it's a very cheap product. So, do that very basic investment expense audit.

Also think about looking at individual holdings, particularly if you have indexed funds and exchange-traded funds in your portfolio. We've seen these incredible price wars going on in the index fund universe, and I think it's important to recognize that you, as a consumer, are a beneficiary. So just make sure that you are looking at your holdings, making sure that if you are owning these commodity-type products that you're not paying any more than you absolutely need to for them. So, I’ve just provided some benchmarks of the very cheapest index-based products that are available today, take a look at your holdings and see how they measure up.

I wanted to spend just a couple of minutes here, and this is such an important topic and one that I talk a lot about on Morningstar.com, conducting a tax cost audit of your portfolio, and here again I'll split it into two tracks. So if you are in accumulation mode, you want to make sure that you are adhering to a couple of best practices for portfolio management, and in turn tax management. So, first of all, make sure that you are maxing out those contributions to tax-sheltered accounts, making sure that you're using asset-allocation principles when you think about putting together your portfolio. So if you have investments that are kicking off high levels of income that is taxed at your ordinary income tax rates, so that would be junk-bond funds, REITs, you want to make sure that you're holding them in your tax-sheltered accounts. If you have taxable holdings in your portfolio, make sure that those are just as tax-efficient as they can be. So, individual stocks, broad market index funds, exchange-traded funds, and municipal-bond funds, if you hold bonds.

For people who are retired, one thing to think about is, if you do have some earned income, think about contributing to a Roth IRA because you can get some money into that Roth category, thinking about using those same asset-location principles, and also thinking about sequencing your withdrawals to reduce the tax drag on your investments. And finally, if you are retired, I think it can make a lot of sense to work with an accountant, not just at tax time, but throughout the year or perhaps earlier in the year, to help you strategize about which accounts to tap for your living expenses in order to create the lowest possible tax drag and keep you in the lowest possible tax bracket.

So I'm going to end it there. We've been through a ton of information, and I am going to entertain a couple of questions here. My colleague, Jason Stipp, has just showed up with a few questions from our users that we've received.

Jason Stipp: Thanks, Christine.

Benz: Thanks, Jason.

Stipp: That was a great presentation. We have a few questions that have come in from readers. We got a lot of questions before your presentation, and a few questions that came in during your presentation. A couple of questions about the need to do housekeeping, to consolidate, find that optimal number of funds. So, [the first question from reader RMSH], "I have several 401(k)s. I want to consolidate and reinvest them before mandatory distributions." We also had reader, Arnold R. say, "My investments are spread over many accounts such as 401(k)s, different brokers and mutual funds. What's the best way to go about getting my arms around all of these funds and then streamlining, making it a little bit simpler?"

Benz: That's a great question, Jason, and you know, I feel passionately about this, and I think it becomes particularly important when you are retired. And one thing we've talked a lot about with our Morningstar.com users is, you don't want to necessarily prematurely think about widow- or widower-proofing your portfolio, but how would your spouse manage this pool of assets if he or she suddenly had to take it over for you?

So, I do think that streamlining the number of accounts can make a lot of sense. One thing particularly for folks who are retired is you want to look for a firm that's a very good bond manager or at least has good bond options available without much of a transaction fee or at a very low cost. So, I would kind of prioritize that in my search, and I think you can winnow down the universe very quickly, if you are kind of having that as a guiding concern. It's not that hard to find good stock managers. Fewer firms really do a great job at fixed-income research. So, I would prioritize that piece of the puzzle maybe when doing my search.

Stipp: A kind of a related question from Marilyn. She had a recommendation to get into 16 funds. I'm not sure who this came from, but she says four bond funds, three large-cap, three mid-cap, three small-cap. She is worried about overlap, which I think is probably a decent concern. So, when you have that many investments, what's a good way to know if you really need all of them or if she is going to see a lot of overlap especially in maybe those large-cap funds.

Benz: Yeah, there again, I think our X-Ray tool or looking at the constitution of each of the perspective holdings would be a good starting point, just seeing how diversified they truly are. Actually, when I think about that proposed portfolio mix, it doesn't sound unreasonable on the fixed-income side, particularly if she is getting close to retired or maybe already retired. It does sound like a little bit much on the equity side, though. So I think arguably you could accomplish the same mission with fewer holdings on the equity side. That's the piece I would focus on.

Stipp: We had a question about accounting for a pension. Art asked, "My wife and I are fortunate to have a defined benefit pension in our retirement. How should that be counted as part of our portfolio mix?"

Benz: That's a great question. So, the starting point for the retirement-planning process is really to look at your certain sources of income that you'll be able to rely on in retirement. So, for many of us that will be Social Security; for other folks--a shrinking segment--it will be a pension. And so from there, then think about your asset allocation for the remaining portfolio.

But generally speaking for people who do have significant pension assets that will be covering a lot of their income, that calls for having relatively less in fixed income, relatively more in equities, in part because more of their day-to-day living expenses are covered by that pension. So they don't need to batten down the hatches quite as much as people who will be drawing primarily from their portfolios.

Stipp: Christine, in your presentation, you talked about doing some analysis at the individual fund level. I'd just like to get a little more detail there. This is a concern from a reader who says, "Every financial person says to try to leave my money in my funds, put my money in and forget about it. But 10 years later, I found that my funds aren't really further ahead than the initial investment. Can you explain what I should do in this situation?"

How does one know when to change funds? So, a long period of maybe mediocre performance, does that mean I need to look for something better?

Benz: Well, first of all I think you need to make sure that you're not looking at returns in a vacuum. So, if you have equity holdings you want to be comparing them to the appropriate benchmark. And so, make sure that you aren't setting unreasonable expectations for them. You actually want to see well did they outperform that much relative to a comparable peer group? Maybe if you get in there and see that relative to the peer group they haven't done that poorly. So I would just make sure that you're using the right benchmark when judging performance.

But certainly I would say if you see prolonged underperformance, and actually I know we provide all kinds of trailing return data on the site, I prefer the year-to-year analysis for a view of what I can actually expect. And I mentioned in the presentation, I think that the past, say, seven calendar years have provided a terrific window into fund behavior. I'd focus in there. Did the fund have a period of distinguished performance during any of that? If it didn't, that's certainly a great big red flag.

Stipp: William asked a question, and I think you've actually written about this. "I would like to use Morningstar's Instant X-Ray, but I don't have ticker symbols for all my investments." So these could be separate accounts. They could be Thrift Savings Plans I think a lot of government employees have. He is looking for a proxy. How do I identify a similar publicly traded fund that they can put in there and get a sense of that X-Ray then?

Benz: It's a great question, Jason. And there are some of these private-label funds that do pop-up in 401(k) plans. So you need to do a little bit of homework about what is in the fund. A lot of separately managed accounts are in fact index funds, so it might be easy to find a proxy in the retail investment space, something that is tracking exactly the same index. So that's an easy one.

It gets a little trickier if it's an active product of some kind. There again I think you need to do your homework. See if you can find a fund manager name. So for example, it might be GE Stock Fund, just throwing that out. I don't know that, a specific investment manager runs that, but see if you can find whether that manager runs a similarly oriented product in the retail space. So you have to do a little bit more homework, but one thing I would note, Jason, is that people shouldn't rule out these non-name-brand funds. Often times they can be very low-cost. So it's worth taking a look rather than just automatically going to the big-name funds that you recognize.

Stipp: Near the end of your presentation, Christine, you spoke a bit about some of the tax issues that an investors should have and keep in mind. We have a question from Ashish who says, "What is the appropriate place to hold bond funds,: taxable accounts or tax deferred?" And he also asks about other types of funds, including munis and some other funds. When you're thinking about where to locate these assets, what should you be looking at when you do your portfolio review?

Benz: It's such an important question. Usually you'd want to have bonds or anything that's kicking off ordinary income in your tax-sheltered accounts, and then save your taxable accounts for things that tend to have more tax-efficient characteristics. I had an interesting conversation with financial planner Michael Kitces recently, though, and his argument was yields on bonds are so low right now, it doesn't matter that much. But I think you need to position your portfolio for what could lie ahead, and I think those traditional asset-location principles will still make sense because I think we will see yields trend up in the future and it will be important to have that stuff stashed within your tax-sheltered accounts.

Stipp: We had another question. You mentioned dollar-cost averaging, so we have a lot of folks who might be out of the market or want to get back into the market, but how to execute that. So over what kind of time period should I wait and put that money in? Any thoughts about the tactical aspect of the dollar-cost averaging approach?

Benz: I would saythat the time horizon for dollar-cost averaging probably depends on how out of sync with your target you are. So if you're dramatically underweight a category that you need to get into, say, you are 20 percentage points light on bonds, I would execute that over a period of years rather than months because that is such a big underweight. And I do think that for people who encounter that situation, they are getting ready to retire, and they’re bonds are light, I think a better strategy rather than moving the money directly into bonds might be actually to derisk right away. Get that money into cash and then employ the dollar-cost averaging strategy.

Stipp: One last question for you, Christine, before we are out of time. I think you will speak about some of these issues this afternoon during your income panel. But I just wanted to get a little preview out there because we got a couple of questions about withdrawal rates, specifically the 4% withdrawal rule, and a reader is asking about the level of returns right now seeming to be lower. What does that mean about the 4% rule? Is it as reliable? So, I am assuming someone maybe has been using this, checking in on their portfolio and wondering, "Should I still stick with this kind of a rule?"

Benz: Yeah, and I referenced in the presentation that there has been some recent research from our colleague, David Blanchett, and a few other researchers actually suggesting a 3% rule is a safer rule. I think that this has obviously set-off huge alarm bells among retired investors who were taking a higher percentage.

I think it pays to step back and think about your time horizon. So a lot of research points to people who are older and further along in their retirement careers being able to take higher withdrawal rates, and people who have very long anticipated retirements want to take much lower withdrawal rates. So, time horizon is in the mix. Also [think about] asset allocation, so I mentioned that the benchmark assumption for that 4% rule is 60% equity, 40% bond portfolio. If you have a portfolio that's 30% equity, 70% bonds, by all means you would want to be thinking about a more conservative withdrawal rate.

I also think, Jason, this is an area that is so important that it’s a great place for people to get financial guidance. I firmly believe that a lot of investors can create their own plans, but I think they might periodically at least need checkpoints along the way. Get some comfort from a professional financial planner who maybe works on an hourly or per-project basis, just to provide you some peace of mind that your withdrawal rate isn't too high.

Stipp: Christine, some great insights, great presentation. Thanks for joining me today.

Benz: Thank you, Jason.