How to Do Your Own Portfolio Makeover

Jason Stipp: I'm Jason Stipp for Morningstar. It's Portfolio Makeover Week on Morningstar.com, and I'm here with Christine Benz. She's going to discuss how you can conduct your own portfolio makeover, if you weren't one of the lucky five to be getting one from her.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: You received hundreds of submissions and requests for portfolio makeovers, but you chose just five. How did you pick those? What were your criteria?

Benz: It was hard, because I received a lot of worthy requests. I tried to focus on a good cross-section of investors, both younger and older investors, and investors with different portfolio sizes. I tried to showcase a variety of situations.

I did put a little more emphasis on people who were closing in on retirement or getting ready to retire, mainly because I receive so many requests from people who are in that general age band. In fact, when I counted things up, probably three-fourths of the requests came from people who were roughly between ages 57 and 63--people who are just about to make that transition into retirement. They're looking at their assets, trying to decide whether they're actually on track to retire within the next few years.

Stipp: There will be a lot of tips and insights that folks can glean just by reading over these five makeovers. But you also say that folks can take some steps to improve their own portfolios in the way that you're doing for these makeovers. The first thing that they should do is take a step back and look at their financial plan: Are they on track?

Benz: That's right. That's what I definitely try to do when I'm doing these makeovers. I start with the big picture, "Is this financial plan on track?" If it's a younger person, is their savings rate on track? Will they potentially have to back-burner some of their short- and intermediate-term goals, if it looks like they're aren't going to have enough in their retirement savings portfolio?

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I'll also look at capital-allocation choices for younger investors--for example, if they have student loans on their books, or maybe they have a home equity line of credit that they've tapped. I'll look at whether it make sense to potentially pay down those debts a little more aggressively, versus investing in their retirement portfolio. I'll try to help with some of those capital allocation choices. So that's something that investors should definitely be taking a look at before they get into the process of reviewing their portfolio plan.

Certainly for older investors who are approaching retirement, one of the key things I think about is their anticipated spending needs in retirement, and trying to help them assess whether that withdrawal rate looks like a sustainable one. I also help them think about what sort of market expectations they have for this portfolio. Are you perhaps being a little bit too aggressive in your return expectations for stocks? Are you using the rearview mirror a little bit too much when thinking about how your portfolio might behave?

So, I start with the financial planning piece, then I get into the portfolio planning piece, because if the financial planning piece isn't on track, no amount of tinkering that we do with that portfolio plan will help make that financial plan come together.

Stipp: The first step when you turn to the portfolio plan is asset allocation, one of the most important portfolio decisions investors will make. What are the decision points you have there?

Benz: I used Morningstar's Portfolio Manager tool to help get my arms around the total portfolio's asset allocation. But I do enter each of the sub-portfolios individually on Morningstar.com. Most investors, especially older investors, are saving in multiple silos; they might have traditional IRAs, they might have 401(k)s, they might have Roth assets, as well as taxable accounts. I actually set up each of those sub-portfolios separately on Morningstar.com, then I use a feature called "Combine," which is part of Portfolio Manager, to bring all those portfolios together. That way I can get the total portfolio's asset allocation view, which as you said, is the most important determinant of how that portfolio behaves.

But I still have all those sub-portfolios saved, so if I need to make some adjustments to the total portfolio's asset allocation, I can do it on the sub-portfolio level. The reason I like to do it that way is that you might have very good reasons to have the sub-portfolios positioned in different ways. That's especially important for folks getting close to retirement, where they're probably going to be drawing down those sub-portfolios on separate schedules. You might have very good reason to have, perhaps your taxable assets positioned a little more conservatively. If you have Roth assets in the mix, you might want to have those be more aggressively positioned. So, I take advantage of that "Combine" feature, which lets me maintain those sub-portfolios, while getting my arms around the total portfolio's asset allocation.

Stipp: And one step down from the asset allocation are things like style allocation and sector allocation. What are you looking for there?

Benz: I definitely keep my eyes open for big bets on given parts of the market, a big small- and mid-cap emphasis, for example. It may be that the investor has some bias toward those portions of the market, but we want to make sure that there aren't any big unintended bets in place.

I check the sector positioning versus, say, a total market index to make sure that we don't have big sector positions in place. I also look for big bets on individual securities; those can often come into play if someone has a lot of company stock in their portfolio. That's usually not desirable to have a portfolio heavily weighted toward company stock. And then I also do some analysis of the quality of the portfolio holdings.

Whether the portfolio has individual stocks, or mutual funds, or ETFs, I rely heavily on our analyst team here at Morningstar to determine which investments should stay in the portfolio and which should go on the chopping block, and I try to be forward-looking.

Stipp: You're looking at things like the Medalist Ratings for funds, potentially, or the moat rating on stocks, and fair value estimates?

Benz: All of our forward-looking ratings.

Stipp:. You also pay attention to what's known as "asset location," which is the types of accounts that are in play for an individual investor. Why is that important?

Benz: I want to make sure that if investors have multiple account types that are open to them, that they're investing wisely among them. For example, the investor who can make a Roth IRA contribution may be better off doing so, instead of investing in a taxable account. I help make some judgments about where it's wise to invest. And then when a person is getting close to retirement, I also help them determine, where are we going to be drawing those assets from during retirement first? And that, in turn, will determine what types of assets we put in which accounts.

Stipp: And lastly, when you're doing makeovers, you have an overarching theme: simplicity. Why is simplicity something that you really find attractive in portfolio planning?

Benz: Many investors, especially investors who are later in their investing careers, do have multiple accounts, and things can get pretty complicated pretty quickly, especially when you have two spouses in the mix who have been saving in their own separate accounts as well. So, I do try to streamline the portfolios as much as possible if we have like-account types. For example, if a person has three traditional IRAs, we might recommend that they roll them together, just so that they have fewer moving parts in the portfolio.

One thing I do keep an eye on, though, is that even though I like all-in-one fund types, I tend not to use them so much, especially if it's a large account, and especially if a person is getting close to retirement. The key reason is that I do think it's very valuable once you're in retirement if you can pick and choose where you go for your cash; you can essentially use re-balancing to dictate where you draw your cash flow from. So, I might tend to actually jettison some of those one-stop funds for investors who are getting close to retirement, simply because they get to exert more control over that portfolio if they have discrete stock and bond holdings.

Stipp: Christine, so many great insights that all investors can glean from your portfolio makeovers. Thanks for the overview today.

Benz: Thank you, Jason.

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