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Investing Specialists

A Year-End Portfolio Review in 8 Short Steps

Warning: The contents of your portfolio have probably shifted in 2016.

As 2016 dawned, few market watchers had high expectations, thanks to the backdrop of slowing corporate profitability and weak global economic growth. Of 18 market strategists surveyed by Business Insider in January, for example, just five foresaw the S&P 500 Index ascending to today’s level of nearly 2,200.

U.S. stocks did get off to a horrible start this year, sliding 6% in January before recovering in March. Stocks sailed through the summer, then underwent another rough patch in October before rallying back sharply in November. Despite an election result that sent shock waves through the country (and U.S. market futures plunging on election night), U.S. stocks have gone onto soar since then. Through early December, the S&P 500 had gained more than 9% for the year; smaller-cap and value-leaning fund categories were sitting on double-digit gains.

Thus, it's highly likely that if you haven't checked your portfolio recently and plan to conduct a year-end review, you will probably be pleasantly surprised by your bottom line. But you're also apt to find that the contents of your portfolio have shifted around a bit.

Even as U.S. stocks have soared, bonds have been in free-fall since the election, stoked by concerns that Trump's stated goals of infrastructure spending, tax cuts, and tariffs on imported goods could lead to inflation and drive up interest rates. All manner of high-quality fixed-income securities have dropped. Most foreign-stock funds have also lost value, owing to a soaring dollar. Emerging markets have also dropped, thanks to Trump-espoused policies that would curb the import of goods into the U.S. from countries such as China and Mexico.

As you conduct your year-end portfolio review, here are the key steps to take.

Step 1: Conduct a "wellness check."
The first step in any portfolio review is answering the most basic question: "How am I doing?"

For accumulators, check whether your current portfolio balance--combined with your expected additions--puts you on track to reach your long-range financial goals. If you're retired, the key metric to keep track of is your portfolio-withdrawal rate. Are you taking money out at a sustainable rate, as discussed in this article?

Tools like T. Rowe Price's Retirement Income Calculator can provide you with a holistic view of your plan's likelihood of success regardless of your life stage. It takes into account nonportfolio income sources such as Social Security as well as the tax treatment of various account types.

If you're using a tool that enables you to enter your own return assumptions, be careful about extrapolating the fairly strong returns during the past decade into the future, as market valuations aren't exactly cheap today. Vanguard founder Jack Bogle makes the case for employing muted return expectations in this video.

If your plan's success is borderline, it's safer to focus on factors that are at least somewhat within your control--such as bumping up your contribution rate, deferring your retirement date, or reducing your planned spending in retirement--than it is to assume that market returns will be as helpful going forward as they have been during the past decade. Additionally, you can look for relatively painless ways to improve your portfolio's prospects: Cutting high-cost investments and better managing your portfolio to reduce the drag of taxes are two ways to enhance your take-home return.

Step 2: Check up on your asset allocation.
If you've been taking a hands-off approach to your portfolio--and that’s usually a pretty good strategy--its contents are likely to have shifted. U.S. stocks have likely grown in importance, even as your foreign and bond holdings have likely reduced themselves. The net effect, especially of an enlarged stock position at the expense of bonds, is that your portfolio likely has more volatility than it did even a year ago.

Investors who have a portfolio saved on Morningstar.com can click on the X-Ray tab in Portfolio Manager to view their total portfolios' allocations; those without a saved portfolio can use the free Instant X-Ray tool. (Incidentally, Instant X-Ray is the easiest way to save your portfolio on Morningstar.com for future assessments; just be sure to click the "Save As a Portfolio" link at the top right of the X-Ray page.)

There's a lot of data on the X-Ray page, but start by checking your portfolio's allocations to U.S. stocks, international stocks, bonds, and cash, and comparing them with your targets. (Don't have targets? A few starting points include Morningstar's Lifetime Allocation Indexes or a good target-date fund geared toward someone with your expected retirement date.) Don't worry too much if your portfolio's allocations diverge from your targets by a few percentage points. But if your stakes in the major asset classes are five or 10 percentage points higher or lower than what you intended them to be, it's time to rebalance.

Step 3: Assess risk in suballocations.
If your stock/bond mix looks off--or even if it looks just fine--it's helpful to assess whether you're making any outsize--and unintended--investment style or sector bets. The X-Ray tool shows you your equity portfolio's investment-style positioning via the Morningstar Style Box, as well as its sector weightings.

In contrast with recent years, when U.S. stocks types experienced similar performance, in 2016 investors have strongly favored value and smaller-cap stocks. Today, total U.S. stock market index funds currently have about 24% of assets in each of the large-cap squares of the style box, 6% in each of the mid-cap boxes, and 3% in each of the small-cap boxes. Investors who have small- and mid-cap value stocks or funds in their portfolios are apt to find that those holdings are especially worthy of trimming following a strong runup in 2016.

X-Ray also depicts your portfolio's sector weightings relative to the S&P 500; armed with this information, you can check up on the valuations of your biggest sector overweightings using Morningstar's Market Fair Value chart. (You can dial into various slices of the market by clicking on tabs such as Sector and Industry on the left side of the page.)

On the bond side, you're apt to find that higher-risk bond types are taking up a bigger share of your portfolio than you intended them to. So far this year, the returns of high-yield, bank-loan, emerging markets and multisector bond funds have been much stronger than higher-quality options. If you're rebalancing your fixed-income portfolio, redeploying money from higher-risk bond segments into lower-risk alternatives (think high-quality, short- and intermediate-term bond funds) will improve your total portfolio's risk level. Of course, higher-quality bonds are often more sensitive to interest-rate changes than are lower-quality options, but high-quality bonds also do a much better job diversifying equity-market risk and reducing overall portfolio volatility.

Step 4: Check adequacy of liquid reserves.
In addition to checking up on your portfolio's asset-class and sub-asset-class exposure, your quarterly portfolio checkup should include an assessment of your cash reserves, which may or may not show up in your X-Ray view. (If you'd like to include cash as part of the X-Ray view of your portfolio in Morningstar's Portfolio Manager, use the symbol "CASH$" or enter the ticker for any money market mutual funds that you hold.)

For retirees, I typically recommend holding one to two years worth of living expenses in true cash instruments. This article takes a closer look at knitting together your various in-retirement financial planning tasks into a single cohesive regimen, including rebalancing and replenishing liquid reserves.

The baseline liquid reserve recommendation for people still working is three to six months worth of living expenses in cash; HelloWallet offers a free calculator to help you arrive at an appropriate amount of emergency reserves, customized based on your own situation.

Step 5: Mind tax effects when making any changes.
If the aforementioned review indicates that changes are in order, assess whether tinkering in your tax-sheltered accounts--where making changes won't trigger a tax bill--can restore your portfolio's allocations back to your targets. Alternatively, if you plan to deploy new money into your investments in the months ahead, you can steer those assets into the investments that you need to top up.

If you've determined that you should scale back on a winning holding in your taxable account, it pays to scout around for losing positions that you can use to offset those gains, as discussed in this article. Alternatively, investors who are in the 15% income tax bracket or below can sell appreciated securities at a 0% capital gains rate, and may even benefit from the tax-gain harvesting strategy discussed in this video.

Step 6: Benchmark your performance.
In a good year for the market like 2016, it's easy to feel like a genius. But rather than resting on your laurels, be sure to check your portfolio's performance relative to a relevant benchmark. A target-date fund geared toward someone in your age band can stand in as a reasonable performance measurement, or you can check your performance relative to a custom-crafted benchmark, as discussed in this article.

Step 7: Assess your asset location.
In addition to checking up on your asset allocation, your year-end review should also include a check of which asset types you're holding in which accounts. Anything that kicks off a high level of current income, whether a Treasury Inflation-Protected Securities fund or a junk-bond offering, is best parked in a tax-sheltered account. This article discusses asset-location basics.

Step 8: Review contributions to tax-sheltered savings vehicles.
If you're still in accumulation mode, year-end is also an ideal time to review how much you're contributing to each of the tax-sheltered account types that are available to you: IRAs, company retirement plans, and health savings accounts. You have until your tax-filing deadline to make contributions to an IRA and/or HSA for the 2016 tax year, but Dec. 31 is your deadline for making 2016 contributions to company retirement plans such as 401(k)s and 403(b)s. Contribution limits for 401(k)s are currently $18,000 for the under-50 set to $24,000 for those over 50.

While you're at it, take a close look at the types of company-retirement plan contributions you're making. Although a lot of variables factor into whether Roth or traditional contributions make the most sense for you, the prospect of higher future tax rates will generally increase the attractiveness of Roth contributions. If you're not convinced of the merits of paying taxes today in exchange for tax-free withdrawals down the line, as is the case with Roth vehicles, you might consider splitting future contributions between both traditional and Roth accounts.