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Benz: 5 Tips for Your Third-Quarter Portfolio Checkup

Beyond noting their stock/bond split, investors should also check their small-cap exposure, overall rate sensitivity, and vulnerability to the wealth effect.

Jason Stipp: I'm Jason Stipp for Morningstar.

How did an eventful third quarter ripple through investors' portfolios? Here to offer five important tips for your quarter-end portfolio checkup is Morningstar's director of personal finance Christine Benz.

Thanks for joining me, Christine.

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

Tip 1: Check Exposure to Major Asset Classes
The first thing investors should check when they're opening up their portfolios at the end of the third quarter is probably the most important thing they should keep their eye on, which is the stock/bond mix. Stock performance this year certainly could have changed the proportion of that mix.

Benz: That's right. The third quarter was very good for equities. The whole year has been very good for equities. So, if you've done nothing to your portfolio in terms of rebalancing, readjusting those asset allocations, chances are they've changed quite a bit, and for a lot of people, that will mean that their portfolios are more equity heavy than they want them to be. That could call for considering whether it is time to rebalance back to your targets.

Stipp: Not only performance, but also it's good to keep an eye on valuations. When you look at the way Morningstar analysts value the stock market, it could be a good time also from that perspective to trim a little bit on stocks.

Benz: That's exactly right. So when we look at our coverage universe, what we see is a price-to-fair-value of about 1.02, a little over fair value currently. That's not a horrible sign for equities. It doesn't mean that equities will fall precipitously from here, but it does indicate that it's probably a good time to consider lightening up on stocks.

Stipp: The bond market has, obviously, been bumpy over the summer. If I'm trimming from stocks, are you telling me that I should take that money and plow it into bonds? Is now a good time to do that?

Benz: It seems very counterintuitive. There's been so much handwringing about what will happen with interest rates, and I think it's really reasonable to think that interest rates will indeed trend up over time, maybe to more normal levels from where they've been. But I do think that investors should, in fact, be taking some risk off the table in their portfolios if they are tilting more heavily toward equities than perhaps they intended.

I think at a time like this it's really important to remember why you have bonds in your portfolio in the first place, and it's the ballast that you need for your more volatile equity holdings. You need to have some very safe and steady holdings. That can be cash, but it could also be short-term and high-quality bonds. So to the extent that people have bonds in their portfolios, I think that they probably want to be thinking about that general complexion, remembering why they have them, and keeping those bond holdings pretty safe.

Tip 2: Check Equity Sub-Asset Class Exposures
We've checked our high-level asset allocation. You say it's also worth looking at some of the sub-asset classes, because we've seen some interesting performance differences among the different types of equities.

Benz: We have, for a change, because we had seen periods in the past couple of years where a lot of equities performed in lockstep. This year we've seen a bit of a gradation. So the big headline is that we've seen small- and mid-cap stocks, small-cap stocks in particular, dramatically outperform large. So if you have a dedicated small-cap fund or an allocation to that asset class, chances are it may be growing a little beyond your parameters for it.


It's important to think about what, say, a good total stock market index fund has in small-cap stocks. It's about 9%. So if you're seeing that your portfolio's overall allocation is double that, that may be a little bit lofty, and I think it's important to remember that small caps have historically been a bit riskier than large caps. So if you are overdoing your allocation to that particular market segment, you may be injecting a little more volatility than you bargained for.

Stipp: Another way we've seen performance differences is in international versus domestic. What should I think as I'm checking my foreign overall global exposure?

Benz: Well, we did see international stocks perform sort of in line in general with U.S. equities during the quarter. So they made up some ground, but generally speaking, you're right, Jason. For the year-to-date, we are seeing weaker performance from international equities. Emerging markets, in particular, have been a weak spot in investors' portfolios. I think there has been a lot of interest in adding to emerging-markets allocations. Our equity analysts actually think when they look at their ratings on stocks on a global basis, on a regional basis, the European stocks actually look the cheapest to them currently.

I think there might be some temptation to dive into some of those unloved areas. My advice for most investors is to probably leave the heavy lifting on that front to a good actively managed fund, maybe one with a value bias. Morningstar analysts have their favorite funds that do use that value tack to managing overall global exposures. [Premium Members can see our analysts' top-rated foreign large-cap funds, world-stock funds, and more.

Tip 3: Check Your Rate Sensitivity
We talked about stocks; let's flip over to fixed income. What should I be checking when I look at my fixed-income holdings? Obviously, investors have been taking a very close look at them as performance had been volatile earlier in the summer. What should I look at now?

Benz: It's interesting, because when you look at fixed-income performance during the third quarter, it actually looks pretty decent in absolute terms, which is somewhat surprising, given that interest rate shock we had in that May/June period. I would say for investors who haven't been through this exercise recently, it's still worth looking specifically at how their holdings performed in that period from early May through early July. It's interesting because that underperformance that we saw during that period may be lost in the shuffle, because it's not showing up in the trailing-period returns. It's not showing up in the one-month returns. It's not showing up in a three-month or year-to-date returns.

But it's worth using the graphing feature on our site [click for example] to look specifically at how your holdings, and maybe especially your fixed-income holdings, performed during that particular period [readers can key in specific date ranges]. If you saw losses that were in the neighborhood of 6%, 7%, 8%, or even higher, it's a good indication that you've got some rate-sensitive holdings in your portfolio.

And don't just look for the regular suspects. Everyone thinks, well, long-term government bonds will perform poorly when rates go up. What we saw was a lot of different asset classes performing poorly during that time period. So, treasury inflation-protected bonds had big losses; emerging-markets bonds and equity funds had big losses, as did some of the rate-sensitive U.S. equities. So, we saw REITs perform poorly. We saw utilities perform poorly during the period. So, just take a closer look at that specific period, even though it won't necessarily show up in your three-month returns.

Stipp: It sounds like it's worthwhile to definitely look at that time period, not only for your fixed income, but across all of your portfolios, just to gauge overall rate sensitivity.

Tip 4: Revisit Munis
The next one, Christine, you say is to take a look at your munis and revisit munis. Munis have been in the headlines and not in a good way, given all the problems in Detroit; now a lot of attention on Puerto Rico. What should I be thinking about as I'm looking at my municipal holdings, or maybe my lack of municipal holdings?

Benz: When you look at the year-to-date performance among fixed-income securities, munis are a notable weak spot. We saw a lot of concerns about Detroit, so the credit concerns are there. The other thing is that munis tend to have a lot of issuance in the long-term range. So, we tend to see a lot of rate sensitivity among some of those holdings.

I think it's important to look at your exposures to the asset class. Interestingly, though, we have seen munis get pretty beaten up, they made up some ground recently. So I do think it's worth revisiting, even if you're not in the highest tax bracket, that 39.6% tax bracket, … if you have bonds in your taxable portfolio, whether muni bonds may, in fact, be a better-yielding area for you than taxable bonds.

A lot of sites have bond calculators, has one; crunch the numbers comparing yields on a taxable-bond fund or bond versus a muni bond or bond fund, and see how you stack up on an after-tax basis in terms of the yield that you might be able to pocket.

Tip 5: Don't Let the Wealth Effect Go to Your Head
The last thing, Christine, you said that investors need to keep in mind as they're reviewing their portfolios is not to let the wealth effect go to their heads. This is especially an issue when you're looking at the bottom line value of your portfolio.

Benz: I think that that's a big issue right now, Jason. I don't know about you, but I've definitely cracked open my 401(k) plan a little more over the past few months, because it's been telling a happy story. We've seen the numbers in our portfolios go up and up and up, and also we've seen home values rise. That provides a lot of peace of mind. It makes us feel good.

I think the risk, though, at a juncture like this is that investors might be inclined to overspend. They see their overall wealth effect, they're calculating their net worth, they're feeling wealthy. So, that's one potential behavioral trap that you could fall into at a time like this.

You might also have a tendency to performance-chase--if not adding more to a specific holding, at least maybe being willing to let your equity holdings ride a little bit longer, and not doing that rebalancing that we all know is good portfolio maintenance.

So, I think it's important to remember at a time like this … everyone quoted Warren Buffett back during the bear market saying to be greedy when others are fearful. I think it's also important to do the opposite: to be fearful when maybe others are feeling a little bit greedy and pull back on those impulses to chase hot performers.

Stipp: Christine, five great tips as we approach the end of the third quarter and open up our portfolios once more. Thanks for joining me.

Benz: Thank you, Jason.

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