Asset Allocation Tips for a Lofty Market

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Christine Benz, she is our director of personal finance, to look at some tips for investing in a lofty market.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's set the stage a little bit. You say this is kind of an unusual situation in which both stocks and bonds look pretty fully priced.

Benz: Right. In many other market environments stocks hand it off to bonds and vice versa that there may be various points in time where one asset class looks attractive and the other one doesn't so much. Right now we've come through a period where stocks have performed really well, bonds have performed really well, too. So, I do think that it creates challenges for investors at all life stages, but particularly for people who are getting close to retirement.

Glaser: But when you think of that stocks-versus-bonds question and in terms valuation, which do you think looks more attractive?

Benz: It's tough to say. Stepping back and thinking about where bonds are today, it's difficult to say that they are expensive because I probably would have said that maybe five years ago and yet we've had a tremendous rally in bond prices; yields have gone down well below what anyone thought they would do. So, today though, when you look at the typical bond fund, intermediate-term bond fund, it has returned about 5% so far in 2016. And then when you look at where yields are today, yields on high-quality bond portfolios are in the neighborhood of 2% currently. And those yields are actually a pretty good predictor of what you're apt to earn from bonds over the subsequent decade. So, a 2% gain from the asset class doesn't particularly inspire a lot of excitement at today's levels.

Stocks, I think, in a similar vein, it's hard to find many market analysts, market researchers who are really bullish about stocks' prospects. The typical stock in Morningstar's coverage universe is trading right around fair value, not egregiously overvalued, but not especially cheap either. I ran a quick screen for companies that have 4- or 5-star ratings currently, that have wide moats, and have low fair value uncertainty ratings, as you know, it's a pretty short list today, just about six pharmaceutical stocks. So our analysts' bottom-up research aren't sending a particularly bullish signal about where stocks are today. Shiller P/E, another metric that a lot of investors look to, a lot of value investors look to, looks high as well, although in the interest of full and fair disclosure, it has actually looked high for quite a while now.

Glaser: But when you think about that stocks-versus-bonds asset allocation question then, how do you think people who are planning for retirement should balance the two?

Benz: I really like the idea of stepping back and as you know, I'm a big fan of the bucket approach to retirement portfolio allocation. And rather than getting too in the weeds thinking about valuations of this or that asset class, think about what are my cash flow needs and how do I stage this portfolio so that I can meet those cash flow needs over my retirement. So in the typical bucket structure that I've set up we've thought about one to two years' worth of living expenses in cash instruments, the idea being that you don't want to take any risk with that portion of the portfolio. Then with the money you have earmarked for, say, the next eight years of retirement, there you want to think primarily about high-quality bonds, maybe even some high-quality dividend-oriented equities in that portion of the portfolio. And finally, if you have a time horizon of 10 years or more, I think it's perfectly reasonable and in fact, quite safe to hold stocks for that portion of your retirement. So I like the idea of using time horizon to help gauge how you position that in-retirement portfolio.

Glaser: How do you think about rebalancing in an environment like this if you're just kind of selling from one thing that's expensive, into something else that's expensive. Is that still worthwhile?

Benz: Well, I think, it is a good time for retirees to revisit their current allocations using a tool like our X-ray tool. Look at what your current allocations are, compare them to your targets; if you don't have targets, you should get them, maybe using the strategy that I just talked about where you kind of do that time-segmentation approach. But compare your current portfolio, make two-year target. For many investors the right answer if they need to do some rebalancing will probably mean scaling back on U.S. equities because even though both U.S. stocks and bonds have performed well, U.S. stocks have outperformed bonds by quite a good margin. So, if investors need to do trimming, it probably will happen there.

One other thing investors should take a look at is their intra-asset class exposures. And in particular today, I think that investors at all life stages should drill into their foreign versus U.S. allocations. We're in a period where over the past decade the MSCI EAFE index of developed foreign stocks has returned about 2% whereas the S&P 500 has returned about 8% over that same timeframe. So, my guess is that in many investor portfolios, they are quite under-allocated to foreign stocks; that would apply to retirees, too.

Glaser: And then how do you think about the risk or additional risk of increasing that foreign allocation?

Benz: Well, it's a good question. Certainly, there are different philosophies on setting foreign versus U.S. allocations in investor portfolios. Our colleagues in Morningstar Investment Management actually think that people approaching retirement and in retirement should dial back their foreign equity exposure and certainly their foreign bond exposure simply because the foreign currency swings associated with those stakes do elevate the risk in the total portfolio. So you are spending in-retirement portfolio in dollars if you have a big shortfall simply because your foreign-currency-denominated securities have depreciated in value relative to...because of the dollar's appreciation, that's kind of a wild card that you just don't want in your retirement portfolio. So, I think looking at sort of a ballpark allocation as a percent of the total equity allocation to foreign stocks is like somewhere in the neighborhood of 25% to 40% of the equity portfolio. That seems like a reasonable starting point.

Glaser: How do you think about withdrawal rates in an environment like this? Should you be adjusting how much you're planning to take out of your portfolio?

Benz: Probably so. In fact, I would say some of the most valuable research in the realm of retirement planning over the past five or seven years has come in the realm of retirement portfolio withdrawal rates. One theme that emerges from a lot of this research is that investors should stay a little bit flexible if they possibly can when it comes to their withdrawal rates. So, specifically, though they may be able to take a little more in high markets, they should plan to be willing to ratchet back when the market falls. So, that's I think something that retirees ought to keep their eye on. If they need to reduce their withdrawal rates, can they do it? Can they be ready if their portfolio incurs a big drop?

Glaser: Withdrawal rates are something investors can control; market returns are not. What other things do you really have in your control in an environment like this?

Benz: In a lofty market environment, I think, it very much benefits you to focus on those factors you can control. Even though they seem to be small, they can actually have a meaningful difference, have a meaningful impact in an era of low returns. So, specifically, everybody hears us evangelize about the importance of costs, but I really do think it makes sense to keep an eye on the costs associated with your investment plans or whether they are direct fund and ETF costs, or your own trading costs, how much you're paying an advisor. Certainly, paying an advisor to help you stay on track can be money well spent, but investors I think should right-size the amount of advice they are getting based on what they need. So, for many investors who are on Morningstar.com, maybe what they need is a once-a-year check-in with an hourly advisor as opposed to that all-in advisor who they pay throughout the year. So that's something to consider. Tax efficiency is another area to keep an eye on as you move throughout your investment lifecycle but especially in retirement, making sure that your withdrawal sequencing is as tax efficient just as it can be, making sure that if you have taxable assets that you are managing them with an eye toward reducing the drag of taxes on them.

Glaser: Christine, thanks for these thoughts on the market environment today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.