A 7-Step Midyear Portfolio Review

Sell in July and go away?

That might look tempting after the tremendous run that both stocks and bonds enjoyed in the first half of 2019. After sputtering badly in 2018’s fourth quarter, stocks regained all the ground they had lost and then some for the year to date through late June. Bonds also performed well, which doesn’t always happen when stocks are soaring. Not only did the Federal Reserve Open Market Committee leave interest rates unchanged at its June meeting, but the Fed indicated that it was standing ready to cut rates later this year if the economy showed signs of further weakening.

Yet even though selling equities entirely, as prescribed by seasonal strategies like the "sell in May" adage, isn't a good idea, midyear is a decent time to take a fresh look at your portfolio and your plan. You may find that your enlarged portfolio is also courting a good bit of risk, which can be particularly problematic if retirement or spending on other goals is close at hand.

As you conduct a midyear portfolio review, here are the key steps to take.

Step 1: See how you're doing. Before you get mired in the details of your portfolio, start with your plan. Are you on track to reach your financial goals?

If you're still accumulating assets for retirement, check on whether your current portfolio balance, combined with your savings rate, puts you on track to reach whatever goal you're working toward. Tally your various contributions across all accounts so far in 2019: A decent baseline savings rate is 15%, but higher-income folks will want to aim for 20% or even higher. Not only will high earners need to supply more of their retirement cash flows with their portfolio withdrawals or other sources (Social Security will replace less of their working incomes), but they should also have more room in their budgets to target a higher savings rate. You'll also need to aim higher if you're saving for goals other than retirement, such as college funding for children or a home down payment. In addition to assessing your savings rate, take a look at your portfolio balance: Fidelity Investments has developed helpful benchmarks to gauge nest-egg adequacy at various life stages.

If you're retired, the key gauge of the health of your total plan is your withdrawal rate--your planned portfolio withdrawals for 2019, divided by your total portfolio balance at the beginning of the year. The "right" withdrawal rate will be apparent only in hindsight, but the 4% guideline is a good starting point. (Remember: The 4% guideline isn't about taking 4% of your portfolio year in and year out.) If you've had a big-spending first half, there's still time to rein it in so that your 2019 withdrawal rate comes in at a comfortable level.

All-in-one retirement calculators can also be useful when assessing the viability of all aspects of your plan. Tools like T. Rowe Price's Retirement Income Calculator and Vanguard's Retirement Nest Egg Calculator bring all of the key variables together and help you identify areas for improvement.

Step 2: Assess your asset allocation. Once you've evaluated the health of your overall plan, turn your attention to your actual portfolio. Morningstar's X-Ray view--accessible to investors who have their portfolios stored on Morningstar.com or via Morningstar's Instant X-Ray tool--provides a look at your total portfolio's mix of stocks, bonds, and cash. (You can also see a lot of other data through X-Ray, which I'll get to in a second.) You can then compare your actual allocations to your targets. If you don't have targets, Morningstar's Lifetime Allocation Indexes are useful benchmarking tools. High-quality target-date series such as those from Vanguard and BlackRock's LifePath Index Series can serve a similar role for benchmarking asset allocation. My model portfolios can also help with the benchmarking process, whether you're retired or still saving. If you're retired, be sure to "right-size" your buckets based on your spending rate, as discussed here.

If you've been hands-off, you may well find that your portfolio is quite heavy on stocks relative to the above benchmarks. A portfolio that is mostly, or even entirely, invested in stocks isn't a huge deal for younger investors with many years until retirement. But a too-heavy equity portfolio is a far more significant risk factor for investors who are nearing or in drawdown mode: Insufficient cash and high-quality bond assets to serve as ballast could force withdrawals of stocks when they're in a trough, thereby permanently impairing a portfolio's sustainability. If your portfolio is notably equity-heavy relative to any reasonable measure and you're within 10 years of retirement, de-risking by shifting more money to bonds and cash is more urgent. You could make the adjustment all in one go or gradually via a dollar-cost averaging plan. Just be sure to mind the tax consequences of lightening up on stocks as you're shifting money into safer assets; focus on tax-sheltered accounts to move the needle on your total portfolio's asset allocation. Step 3: Assess adequacy of liquid reserves. In addition to assessing your portfolio's long-term asset allocations, midyear is a good time to check your liquid reserves. If you're still working, holding at least three to six months' worth of living expenses in cash is a good target. Higher-income earners or those with lumpy cash flows (looking at you, "gig economy" workers) should target a year or more of living expenses in cash. For retired people, I recommend six months to two years' worth of portfolio withdrawals in cash investments; those liquid reserves can provide a spending cushion even if stocks head south or bonds take a powder. (Financial planner Harold Evensky, who I consider the originator of the bucket approach, says he targets one year's worth.) Retirees whose portfolios are equity-heavy can use rebalancing to top up their liquid reserves.

In addition to checking up on the amount of liquid reserves that you hold, also take another look at where you're holding that money. Cash yields have declined a bit in 2019’s first half, but they’re still better than they were a few years ago. Online savings accounts are usually among the highest-yielding FDIC-insured instruments, but money market mutual funds, which aren't FDIC-insured, offer you the convenience of having your cash live side by side with your investment assets. Yields on brokerage sweep accounts, which offer convenience for traders who like to keep cash at the ready, are often stingy on the yield front.

Step 4: Assess your equity portfolio positioning. Your broad asset-class exposure will be the key determinant of how your portfolio behaves. But your positioning within each asset class also merits a closer look. In keeping with a pattern we've seen for several years running, domestic growth stocks and funds have still outperformed value names by a wide margin thus far in 2019. Check your portfolio's Morningstar Style Box exposure in X-Ray to see if it's tilting disproportionately to growth names. As a benchmark, a total U.S. market index fund holds roughly 25% in each of the large-cap squares, 6% apiece in the mid-cap boxes, and 2% in each of the small-cap boxes. Not every portfolio has to be right on the top of the index, but the style-box view lets you see if you're making any big inadvertent bets.

While you're at it, check up on your sector positioning; X-Ray showcases your own portfolio's sector exposures alongside those of the S&P 500 for benchmarking. Additionally, check your portfolio's allocation to foreign stocks: They've performed quite well recently, but have generally gained less than U.S. stocks during the current bull run. Foreign stocks won't necessarily perform better than U.S. in an equity-market sell-off, and may even underperform the U.S. But younger investors, especially, should be on guard against "home-country bias," which can undermine their portfolios' long-term returns. It's also worth noting that experts are forecasting higher returns from foreign stocks than the U.S. over the next seven to 10 years.

Step 5: Evaluate your fixed income exposures. On the bond side, review your positioning to ensure that your bond portfolio will deliver ballast when you need it. Thus far in 2019, risk-taking has been rewarded for bonds as well as stocks; categories like junk bonds and emerging-markets bonds have scored strong gains. But when your equities are down, history suggests that the most boring, highest-quality bonds will tend to hold up best. If you're adjusting 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 diversification and risk level.

Step 6: Check up on your holdings. In addition to checking up on allocations and sub-allocations, take a closer look at individual holdings. Scanning Morningstar's qualitative ratings--Morningstar Analyst Ratings for stocks and Morningstar Medalist ratings for mutual funds and exchange-traded funds--is a quick way to view a holding's forward-looking prospects in a single data point.

If you're conducting your own due-diligence, be on alert for red flags at the holdings level. For funds, red flags include manager and strategy changes, persistent underperformance relative to cheap index funds, and dramatically heavy stock or sector bets. For stocks, red flags include high valuations and negative moat trends.

Step 7: Make changes judiciously. Whether you act on any of the conclusions you drew from your fact-finding depends on a couple of factors--the type and severity of the issue, as well as your life stage and situation and the parameters you've laid out in your investment policy statement. (If you don't have an IPS, you can use this template to create one.)

If you’re many years from retirement, tend to be unruffled by market volatility, and your portfolio has 90% in stocks even as many asset-allocation benchmarks suggest 80% or 85% for people at your age, repositioning your long-term portfolio probably isn’t urgent. But if you do decide to make changes, be sure to take tax and transaction costs into account. Focus any selling in your tax-sheltered accounts, where you won’t incur tax costs to do so, and you can usually skirt transaction costs, too.

Making changes can be more pressing if you're getting close to or in retirement, especially if your portfolio is too aggressively positioned and you don't have enough in safe assets to tide you through sustained weakness in the stock market. In that case, it's wise to think about redeploying some of your enlarged equity portfolio into cash and bonds. If you're subject to required minimum distributions, consider harvesting appreciated equity holdings to help source your distributions; you don't have to wait until year-end to do so. This article discusses the topic in greater detail.

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