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How to Stay Tough in Difficult Markets

How to Stay Tough in Difficult Markets

Susan Dziubinski: For Morningstar, I'm Susan Dziubinski. Market volatility has returned with a vengeance this year. I'm here with Christine Benz, our director of personal finance, to talk about what's been driving that volatility and what investors should do about it.

Christine, thanks for joining me.

Christine Benz: Susan, it's great to be here.

Dziubinski: What's been driving the volatility so far in 2018?

Benz: We had some volatility earlier in the year back in February, and that seemed to center around concerns over inflation, fears that maybe the tax cuts would be inflationary and also concerns about rising interest rates. More recently I would say, the market volatility has been focused around worries related to tariffs and trade wars. I would say more broadly with the market being, in Morningstar's view, pretty fairly valued, we tend to see the market more sensitive to some of these headline risks that crop up, inevitably. I think that that enhances the potential for volatility.

Dziubinski: Is the volatility we're seeing historically abnormal, or is this just a return to the more normal levels of volatility historically?

Benz: Yeah. In a lot of ways, it is a return to more normal levels. I was looking at the VIX, which is the CBOE's benchmark of volatility. What you see from 2012 through really last year, 2017, was a remarkably placid period, a little spike up in volatility back in 2015. But when you look at the volatility we've seen more recently, it just really does look quite similar to the period prior to that 2012 through 2017 period. I think we all got a little bit a little bit spoiled. We were used to having our equitylike returns but didn't have to endure a lot of price volatility to get it.

Dziubinski: In periods of market volatility that we've seen recently and that we've seen in the past, you often suggest that investors focus on the big picture. What do you mean by that specifically?

Benz: For one thing, step away from those holdings, because when the market is volatile, I think a lot of us are naturally inclined to get in there and say "OK, what are my problem children in my portfolio? What's holding up well." We move directly to that portfolio. I think it does make sense to take a step back, think about how you are doing in relation to your plan. If you're someone who is still accumulating assets for retirement, think about your savings rate. Maybe you've been relying too much on the market to do the heavy lifting of enlarging your balance, so make sure that you are saving as much as you possibly can.

I think a good benchmark is 15% of salary to try to save, but certainly if you're a high-income earner, you may be able to set aside a higher amount of your paycheck maybe 20% or even 25%. If you are someone who's retired the key thing you want to look at in terms of how you are doing is your personal spending rate, your portfolio spending rate. Check up on that if you haven't done so recently. With portfolio balances enlarged, I think perhaps some retirees have gotten maybe a little bit loose on the spending front. They've seen their portfolios nicely growing, so they've perhaps been taking a little bit more than they otherwise would, get back to looking at what is a sustainable withdrawal rate for you. We've certainly written a lot about this topic on Morningstar.com, but this is another area where a financial advisor can be a great help in terms of putting a little bit of science around whatever withdrawal system you're using.

Dziubinski: If investors are looking at their plans and their portfolios either because they are doing a midyear checkup or because of the market volatility, what sort of return expectations would you suggest that they use going forward?

Benz: It's a great question, and my view given where we are in terms of market valuations is that investors should be conservative. When you're thinking about your equity portfolio, I would be careful about using a return assumption much higher than midsingle digits. If you have say a 10-year time horizon, you'd want to be pretty conservative about what you'd expect from the equity piece of your portfolio.

If you are someone with a long time horizon, so maybe you are an early accumulator, and you have many years until you'll retire, there I think it's safe to get back to maybe a long-term historical market returns to help guide your expectation, so maybe high single digits. For the bond market it's a little easier, because historically starting yields have been a good predictor of what to expect from the bond market over the subsequent decade. With the Bloomberg Barclays Aggregate Index currently yielding about 3%, I think it's safe to plug that in as your return expectation for fixed income markets.

Dziubinski: You've also been talking and writing about the importance of investors re-examining their asset allocation and possibly rebalancing. Can you talk a little bit about that in this environment?

Benz: That's another thing if you're thinking big picture, focus on your asset allocation before you move into individual position management. Use Morningstar's X-ray tool help see how you are actually positioned based on the composition of your portfolio. If you've been super hands off with your portfolio, and maybe you had a 60/40 portfolio back in 2009 when this great rally began, you'd be over 80% equity today. Many investors I think have been kind of coasting. It's been easy to feel complacent because market performance has been so good. Take a look at your current asset allocation, compare it to your target.

A lot of people might say, I don't have a target, in which case, I would say there are some quick and dirty ways to figure out an appropriate asset allocation. I often say look at Morningstar Lifetime Allocation Indexes as a benchmark. You might also look to a good target-date fund geared toward someone in your age band. This is also a spot where a financial advisor can provide some really helpful guidance in terms of customizing your asset allocation based on your own situation.

Dziubinski: What if an investor looks at his or her plan and finds, my asset allocation is out of whack, relative to where it should be and, in many cases, I would suspect these investors are going to see they are maybe too light on bonds. What do you think about bonds right now? Isn't it a little bit risky to be going into that part of the market, specifically right now?

Benz: Certainly, investors are concerned. We have seen yields trending up. The Federal Reserve has taken action to increase interest rates back to more normal levels. They've indicated that there will probably be further rate increases later this year. Investors are maybe quite reasonably spooked about what's next for bonds.

A couple of key things I would say is that, while there might be some price-related volatility in the near term, as interest rate suggest upward, over time if you have a long time horizon, higher yields are to your benefit if you are someone who owns bonds in your portfolio. Then another key thing to keep in mind is that, even a really bad period for bonds is going to be nothing like a really bad period for equities.

I think some perspective is in order. Even though we do expect interest rates to trend higher, I don't think anyone is assuming that Armageddon is upon us for the bond market. I think that rate hikes will probably proceed in a pretty deliberate fashion. I think in my view that investors are overdoing a little bit in terms of worries about the bond market.

Dziubinski: Let's say an investor has taken a look at the big picture and is taking care of that, you've also recommended playing small ball. What do you mean by that?

Benz: Naturally, you'd want to take a look at how your various holdings are performing. But I think, take a step back from that and focus on holdings' quality and certainly, we have a lot of great resources on Morningstar.com for checking up on holdings' quality. If you're an equity investor, you'd want to look at star ratings, moat ratings and so forth. If you are an ETF, an exchange-traded fund, or mutual fund investor, you want to look at our analyst Medalist ratings.

Start by checking up on holdings' quality. Also, take a look at expense ratios if you've managed products in your portfolios. Take a look at tax efficiency. Make sure that you are maxing out all of the tax-sheltered vehicles that are available to you, if you're someone who's accumulating assets for retirement. If you have taxables or nonretirement assets, make sure that you're managing those as tax efficiently as you possibly can. Really focus on those things that are within your sphere of control. I think that's a good way to kind of take back some control in an uncertain market environment.

Dziubinski: Christine, so much great practical information. Thank you for joining us today.

Benz: Thank you Susan.

Dziubinski: From Morningstar.com, I am Susan Dziubinski. Thank you for watching.

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