7 Takeaways From Portfolio Makeover Week

Morningstar's annual Portfolio Makeover Week is designed to be educational for our readers, but I always end up learning a lot along the way, too. Reviewing portfolios, working with the individuals behind each of the portfolios, and hearing Morningstar.com readers' views on the "before" and "after" versions also provides a window into what's on investors' minds these days--and gives me ideas about topics that I should be working on in the future.

As I think back on last week's series of portfolio makeovers--the makeovers themselves as well as user feedback on them--here are some of the key takeaways.

1. Portfolio clutter is common but not unavoidable. It's easy to become an investment "collector," and indeed, many of the portfolios featured were unwieldy before (and some readers argued, after, too!). But having too many holdings can increase investors' oversight responsibilities and may also jack up costs; why hold a bunch of individual stocks or sector-specific ETFs when you could more cheaply buy a broad market index fund? Thus, a key goal for each of the portfolio makeovers was to identify ways that I could streamline and simplify. Could like-minded accounts be consolidated? Could small positions in less-diversified holdings be excised and the money redeployed into better-diversified, lower-cost, higher-conviction positions? Oftentimes the answer was yes. If you're undertaking your own portfolio makeover--or simply conducting a year-end portfolio review--look for opportunities to cut the clutter in your own portfolio. Operating with an investment policy statement--a basic blueprint that spells out your portfolio plan and what criteria you'll apply when selecting investments--can help you avoid nonessential portfolio holdings in the first place.

2. There are practical limits to simplifying. As much as I sought to simplify the portfolios, the makeover series was a reminder that there are limits to doing so. Monday's makeover, featuring the portfolios of two young retirees, provided a good illustration: The couple had retirement accounts in their own names, as well as IRAs inherited from two separate individuals; those accounts needed to remain distinct for tax reasons. And while single well-diversified funds, such as target-date or balanced funds, are superb core holdings for accumulators, my view is that accounts that are currently in drawdown mode should include distinct holdings representing the major asset classes rather than all-in-one-products. That structure enables the retiree to cherry-pick his or withdrawals from the asset class that is most advantageous at any given point in time. In 2017, equities' appreciation means stocks are good candidates for selling; in weak equity markets, pulling withdrawals from cash will be the way to go. (This is the heart of the bucket approach to retirement portfolio management, which I've written about extensively.)

3. Idiosyncratic risk is not helpful, especially as you age. In addition to streamlining, another of my key goals during the makeovers was to reduce idiosyncratic risk--big positions in individual stocks, sectors, and investment styles, for example. True, most of the big financial success stories we encounter revolve around someone betting heavily on something: Bill Gates didn't amass his wealth by parking his money in an S&P 500 index fund. But even as concentrated positions have the potential to generate outsize returns, they also tend to increase volatility and indeed the possibility of actual losses. They also increase the risk that even if the market is going in one direction, your portfolio could go in another. My view is that while investors need equity risk throughout their lives to help their portfolios grow above the inflation rate, they don't need big side bets on additional factors, whether individual stocks, region-specific mutual funds, or sector ETFs. I was especially vigilant about excising idiosyncratic risk in the portfolios of older adults, who have less time to recover from risky bets that don't pan out. To provide broad, low-cost asset-class exposure, I employed a lot of index mutual funds and ETFs in the "after" portfolios. Such holdings have the salutary benefit of being extremely easy to monitor: If a portfolio is composed of basic building-block investments like index funds, it's simple to correct when the total portfolio's allocations fall out of line.

4. One-size-fits-all asset allocations don't fit, especially in retirement. Several readers wrote that they were surprised about how much--or how little--equity exposure my "after" portfolios included for people in their 50s, 60s and 70s; they noted that the allocations didn't jibe with other sources of asset allocation guidance they'd seen. Resources like Morningstar's Lifetime Allocation indexes or good target date series like Vanguard's and BlackRock's can provide a valuable sanity check when setting your portfolio's asset allocation, especially if you're still accumulating assets for retirement. But when it comes to setting your stock/bond/cash mix in retirement, there's no substitute for letting your actual cash flow needs drive how much you hold in cash, fixed income assets, and stocks. If you're lucky enough to be drawing very lightly from your portfolio, as was the case with the pension-rich couple I profiled Wednesday, there's no reason to hold a very large position in cash and bonds unless you're averse to volatility. Of course, there's an opposite school of thought; if you've won, quit playing (don't invest any more in equities than you really need to). But for many investors I encounter, growing their portfolios for their heirs, charity, or even greater peace of mind is still a priority. Pulling way back on equities wouldn't be appropriate.

5. Investment selection isn't necessarily the biggest determinant of the success or failure of a financial plan. Working with actual investors on their portfolios reinforces how many variables affect the success or failure of a financial plan. Yes, investment choices matter, but whether you reach your financial goals also depends on your savings rate (and withdrawal rate in retirement), health, workplace benefits, insurance choices, and so on. That underscores the importance of considering your portfolio as part of a total mosaic. If you're hurtling toward retirement without long-term care coverage, for example, it pays to understand the potential implications for your in-retirement spending and asset allocation. If you're heeding the oft-cited advice to delay Social Security, have you considered how delayed filing will affect early retirement portfolio withdrawals and taxes? Because so many variables of financial planning are interrelated, it's important to think holistically about your plan rather than looking at your portfolio in a vacuum. If you're working with a financial advisor to help manage your investments, make sure he or she is considering nonportfolio variables as well.

6. Getting money into the market is easier said than done. A few of my portfolio makeovers called for heavier weightings in equities than in the "before" portfolio. Given the equity market's long runup, however, it's reasonable to go slowly when deploying new cash into stocks; you wouldn't want to move a lot of money into the market only to watch it fall sharply thereafter. But what are the logistics of "go slowly"? There are a couple of key ways to approach it. The first would be to straight-up dollar-cost-average--deploying fixed sums at regular intervals (say, every month) until all the money got into the market. Alternatively--and this veers dangerously close to market-timing--you could wait until market downdrafts to put the cash to work. For example, you could invest 20% of the cash if the S&P declines by 5%, another 20% on the next 5% downdraft, and so on. It's also important to note that these timing decisions matter more for people in or approaching retirement and less for young accumulators. That's because young investors have many years to recover from a poor initial timing decision, and future portfolio additions are likely to be more significant than the earliest investments, even if they're ill-timed.

7. Engineering change can be costly on the tax front. In addition to potential timing mistakes, this round of makeovers illustrates another potential peril for investors reshaping their portfolios today: bigger tax bills. While you can fiddle with your tax-sheltered accounts without having to worry about triggering a tax bill, making changes to taxable holdings can result in realized capital gains. That's a particular risk today, given that many of investors' taxable holdings have likely appreciated sharply since original purchase and offsetting losing positions are few and far between. Here again, moving slowly is prudent, as the tax costs of giving your taxable portfolio a makeover could outweigh the benefits you gain through the repositioning. If you're mulling changes to improve your taxable portfolio, check with a tax advisor to assess the implications. Investors in the 10% and 15% tax brackets have less to worry about, as they currently enjoy a 0% capital gains rate and may in fact benefit from tax-gain harvesting, discussed here.