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Lessons From Portfolio Makeover Week

On the short list: You're concerned about retirement readiness, index funds are easy to recommend, and 'more' isn't always better than 'enough.'

Morningstar.com's annual Portfolio Makeover Week, which runs around this time every year, always feels a little like college finals week for me. Between the screening of many worthy requests for makeovers to the number-crunching, spreadsheet-jockeying, and corresponding with the subjects of the makeovers, I'm intensely busy for a good month before the makeovers start to go live. (Text from my sister last night: "Are you done with that project yet? I hope so!")

And yet Portfolio Makeover Week is also incredibly gratifying. Much like a test, it's a chance to show what I know--to bring into practice a lot of the concepts I discuss throughout the year, from portfolio planning to tax considerations. But by far the best part of the project is I get that to hear from so many real-life investors about their goals, their challenges, and the big and small things that make them happy. The project underscores the inextricable link between financial well-being and overall well-being, but it also makes clear that you don't need to be rich to be happy. Interacting with actual investors helps make me better at my job.

As I reflect on last week's makeovers, as well as the many situations I reviewed when winnowing down the list of candidates to the five that were eventually featured, here are some of the key lessons that stand out, in no particular order.

It's hard not to opt for index funds. Flows into index funds, especially exchange-traded funds, have been staggering over the past several years, and I found myself gravitating to them for the makeovers as well. If a household's finances are tight, as was the case with the couple I featured on Day 5, lowering a portfolio's costs by selecting inexpensive products is a risk-free way to help improve the plan's likelihood of success. Moreover, I invariably strive to simplify and reduce idiosyncratic risks in the portfolios I feature, and switching to broad-market index trackers furthers those goals as well.

Finally, I want all of the holdings in my "after" portfolios to feature holdings that I know will be stable in the decades ahead and don't require oversight. Index funds check that box, too. That's not to say that index funds won't experience volatility; they absolutely will. But it's hard to argue with their value as essential building blocks in investors' portfolios. I firmly believe the trend toward index products is not going to reverse itself in a meaningful way.

The math is ugly for high-cost bond funds. In a related vein, I was struck by some of the high fees being levied on active bond funds that popped up in some of the "before" portfolios--90 or 100 basis points or even more. (These weren't fly-by-night bond funds, either; they were giant, widely owned ones.) That's stunning when you consider that starting yields are a good predictor of what bonds are apt to earn over the next decade, and most intermediate-term bond funds are yielding about 3.25% to 3.5% today. By paying 0.90% or 1.0% for a bond fund, an investor is effectively ceding about a third of her likely take-home return. Actively managed intermediate-term bond funds, in contrast with most equity mutual funds, have actually made a decent case for themselves over index products over the past decade, as John Rekenthaler notes. But whether that advantage persists into the future is an open question. And in any case, the subset of active funds with low costs tend to persistently outperform the high-cost ones. For my "after" portfolios, shedding high-cost bond products in favor of cheaper ones was a no-brainer.

Retirement readiness is on your mind. As usual, a huge percentage of the submissions I received were from people getting ready to retire. So many of the emails began with some variation on "I'm 64 and my wife is 63 …" It's easy to see why people would seek another check on their plans at this life stage, because retirement is so much more complicated than the accumulation years. Pre-retirees have to figure out whether they have enough, how much they can reasonably spend each year, and how their portfolios should be allocated to meet those cash-flow needs. And then there's a whole set of nonportfolio considerations, such as Social Security filing and managing healthcare expenses. Because retirement planning is so complex, I believe that even seasoned investors need a helping hand in transitioning to retirement. For investors on a tight budget, seeking planning guidance from a certified financial planner who works on an hourly or per-engagement basis can be cost-effective; investors might also avail themselves of planning help on offer at the investment firm they do business with.

Don't underrate consistent employment and a good match. While many of the requests for makeovers were from people who were approaching retirement or already retired, I always aim to feature one or two younger investors, too. This year, I settled on two 40-something couples who were balancing college funding for their kids with their own retirement savings. In both cases, they'd amassed sizable retirement portfolios: a portfolio over $1 million, in the case of the dual-income couple, and approaching $1 million in the case of the single earner. What struck me was that there hadn't been any particularly investment genius involved in amassing those portfolios. Rather, they'd all been steadily employed and steady savers since their 20s; as their salaries climbed with their responsibilities, they were able to save more. A strong market and stock-heavy portfolios over the past decade also helped, as did generous matching programs from their employers.

'Enough' can beat 'more.' For people like me who have been weaned on the concept of trying to maximize a portfolio's risk-adjusted returns, the situation featured on Day 1 of the series was illuminating. Ted, the retiree in the article, was making do on Social Security and extremely modest portfolio withdrawals of less than 2%. His portfolio was also extremely conservatively positioned, featuring just a third of assets in stocks. I had some concerns about the effect of inflation on such a conservative portfolio, especially because he noted that his healthcare expenses were beginning to flare up. But in hindsight, I think my increase of stocks in the "after" portfolio was more reflexive than it was necessary. I plumped up the equity position because his spending rate was so low; he absolutely could afford to take more equity risk. And switching into a more aggressive portfolio mix would probably enlarge his eventual balance, which he could use for travel or pass on to his daughter. But as Ted himself and readers were quick to remind me, enlarging his equity position wasn't necessary if a more conservative mix allowed him to meet his cash-flow needs and provided peace of mind.

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