Checking Up on Your Portfolio? Let Our Pyramid Guide the Way

Last fall we introduced an investment pyramid to help investors assess their financial priorities. Like the original food pyramid, the items toward the base of the financial pyramid are the most important--the equivalent of whole grains, fruits, and vegetables. 

Meanwhile, the top of the pyramid features items that have less of an impact on the success or failure of their financial plans. Think of them as the investing equivalent of sugars and fats: They keep life interesting, but they're not essential to keeping us running in peak form and can even work against us in outsized quantities.

As you periodically check up on your portfolio, the pyramid can be a useful source to determine where to focus your energies. Give relatively more time and attention to those items that will really make or break your plan, while spending less time on those items that won't have much of an impact.

 

Here's a portfolio-review checklist informed by our pyramid.

Checkup Item 1: Have your goals changed?
The base of the financial pyramid is "having a goal," or more specifically, identifying and quantifying what you want to achieve with your money. Thus, the first step of any sort of financial-review process should be to reassess your goals. Has anything changed in terms of what you'd like to achieve, how much it will cost, when you'll need the money, and for how long? 

For example, have you decided you'd like to retire five years earlier than you had originally expected, thus necessitating that you come up with a larger nest egg well ahead of your previous plan? Or perhaps your child has decided to go to community college for two years before moving on to a four-year university, so your total outlay for higher education will be lower than you anticipated. Any substantive changes in your goals--the amount, your distance to them, and their duration--should prompt a re-evaluation of your whole plan.

If you haven't done so already, group your goals into one of three bands: short-term goals (goals you'd like to achieve in five or fewer years), intermediate-term goals (five to 15 years from now), and long-term goals (15 years or more in the future). Once you've done that, prioritize your goals within each time frame. Be sure to include debt retirement on your list of goals. 

The next step is to estimate exactly how much those goals will cost you. If your goal is close at hand--such as buying a car next summer--quantifying it is straightforward. But if it's a goal that's further in the future or one that you'll pay for during several years, the calculation may be more complicated; you'll also have to factor in inflation as well as assume a reasonable rate of return from your investments. This tool can help you calculate the cost of college using historical (and historically scary) inflation rates, and this basic calculator shows you how much you'll need to save for retirement.

Checkup Item 2: Is your savings or spending program on track?
The next band of the pyramid is "managing your saving and spending rate." Thus, if you're in accumulation mode, a key focus of your portfolio review should be to determine whether your current savings rate puts you on track to hit your financial goals. Or do you need to kick up your savings to improve your probability of success? For retirement planning, tools like T. Rowe Price's Retirement Income Calculator allow you to see how much you'll have in retirement based on your current savings rate. The tool is holistic and factors in Social Security and pensions as well as the tax treatment of your assets (whether you've saved in a Roth IRA, Traditional 401(k), and so on).

If you're already retired and in withdrawal mode, a key thrust of your portfolio review should be to take stock of your spending rate. Does it fall within the guidelines you've laid out for yourself? This article details some common pitfalls to avoid when you're in drawdown mode.

Checkup Item 3: How does your asset allocation compare with your targets?
Asset allocation is the next band of our pyramid, and checking up on your stock/bond/cash mix should be high on your priority list, too. After all, how you've apportioned your assets is one of the most, if not the most, important determinants of how your portfolio performs. Morningstar's X-Ray functionality is the best way to get your arms around your total portfolio's positioning, taking into account the composition of each of your underlying holdings. (If your domestic-stock fund holds cash or foreign stocks, for example, X-Ray will pick up on it.)

Compare your portfolio's X-Ray allocation with those of your targets. If you don't have any targets, Morningstar's Lifetime Allocation Indexes and/or a good target-date series can help provide some guidance. Because those allocations are geared toward the average person with your retirement date, be sure to take into account your own personal circumstances when setting your own asset-allocation parameters, as discussed in this article. For example, if you have a pension that will supply a big portion of your in-retirement income needs, you could reasonably run with a much higher equity allocation than would be standard for someone without a pension in your age band.

Checkup Item 4: Does your portfolio align with your risk tolerance? Are you reducing exposure to the market's hot spots?
Classical economic theory holds that people are purely rational actors when it comes to making financial decisions. Because stocks generally return more than other asset classes over time, for example, investors should be comfortable sitting tight with equity-heavy portfolios despite their inevitable bumps along the way. Students of investor behavior know that it doesn't always work that way, however. Some investors get spooked and abandon stocks in periods of market volatility, while lofty markets often lead investors to enlarge their stock allocations. Morningstar's Investor Return data illustrate how these behavioral errors eat away at investors' take-home returns, sometimes exacting higher tolls than even their funds' expense ratios. That's why "Managing your own behavior" is the next band in the pyramid.

To make sure your portfolio syncs up with your own ability to tolerate fluctuations, the next phase of the review process homes in on the risks associated with your portfolio. In addition to making sure your asset allocation looks reasonable given your life stage, check your portfolio's style, sector, and geographic exposures alongside relevant benchmarks to make sure you're not making any big, unintended bets. X-Ray shows you your sector positioning relative to that of the S&P 500. For a check on your Morningstar Style Box positioning, a total U.S. stock market index currently holds about 24% in each of the large-cap squares of the style box, 6% in each of the mid-cap squares, and 3% in each of the small-cap squares.

Morningstar's Market Fair Value graph is another tool you can use to help ensure you're not running headlong into overheated asset types, which is arguably the biggest behavioral risk for investors right now. Although the stocks in our analysts' coverage universe are, in aggregate, looking slightly overvalued, some cuts of the market look pricier than others. Narrow- and no-moat stocks are a touch cheaper than shares of wide-moat firms, for example. Meanwhile, stocks in the utilities, technology, and industrials sectors currently appear to be the priciest pockets of the market.

Checkup Item 5: Have you maxed out your tax-sheltered accounts? If any changes are warranted, can you make them in a tax-sensitive way?
"Being tax-efficient" is the second-to-last item in our pyramid, and it's valuable to stitch tax matters into your checkup process, too. If you're in a position to contribute the maximum allowable amount to your company retirement plan and IRA, assess whether your current contribution rate puts you on track to hit the limit by year-end.

And if running through the preceding steps indicates that portfolio changes are in order, ensure that you're making them in a tax-sensitive way. Concentrate any selling in your tax-sheltered accounts because trading there won't trigger capital gains taxes.

Checkup Item 6: Are your holdings on track?
"Investment selection" is at the top of the pyramid. That doesn't mean you should ignore it, but it shouldn't be your preoccupation, either. As you conduct your portfolio checkup, don't focus disproportionately on individual holdings' absolute returns and return rankings, though they can be difficult to ignore. Instead, concentrate on fundamentals, revisiting whether your reason for holding each position remains intact. (Ideally, you've laid out your basic holdings parameters in an investment policy statement.)

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