Your 2022 Midyear Portfolio Checkup

The portfolio tuneup information shown in the webcast is available for download. Disclosure information is available at the end of the broadcast.

Many investors conduct midyear portfolio reviews to check their progress against their goals, evaluate their investments, and sometimes rebalance. In 2022, however, a midyear portfolio checkup may seem more daunting in light of today's economic climate and down market for both stocks and bonds.

In this webcast, Christine Benz helps investors conduct productive midyear portfolio checkups. She covers:

• Year-to-date market performance.
• Portfolio strategies for the remainder of 2022.
• The impact that rising interest rates have on investments.
• The impact of inflation on investments.
• How to build a recession-proof portfolio.
• Tax to-dos: Tax-efficient investing.

Christine Benz: Hi, I'm Christine Benz. I'm director of personal finance and retirement planning for Morningstar.

The first half of 2022 was incredibly volatile in the markets. I'm going to talk to you about how to check up on your portfolio at midyear. I'll start by reviewing the market's action for the year to date, and then I'll talk about how that might translate into how to think about your portfolio's asset allocation and its intra-asset allocation, and there's a good news story in there. Then, I'll talk about how to check up on your portfolio's interest-rate sensitivity. A lot of the volatility that we've seen in the market for the year to date has been driven by rising interest rates. I'll talk about how to check up on your portfolio's sensitivity to further interest-rate changes.

Then, I'll talk about what is a relatively new topic in our discourse, which is the topic of recession or a weakening economy. I'll discuss why some economists think that the economy could, in fact, soften in the second half of this year, and I'll discuss how to ensure that your portfolio is protected against a weakening economic environment. I'm going to next talk about inflation, how to inflation-protect your portfolio, as well as your total financial plan. How to look at how insulated you are against the ravages of higher costs.

I'll also talk about a silver-lining story, I think, in the current market environment, which is the opportunity to potentially enact some tax changes to reduce your tax bills going forward. So, I'll share some strategies to think about specifically related to your taxable account as well as related to your IRA accounts.

Market Performance Year to Date

So, let's start by reviewing what has just happened in the market so far this year. This looks back through 2021, and what you can see over this period--this is kind of a periodic table of elements that looks at asset-class returns over the past 15 years--what you can see is a lot of blue at the top. Blue represents large-cap U.S. stocks as well as small-cap U.S. stocks. They had an incredibly strong run really coming out of the bear market in the late 2000s, and they led the way for the broader markets over the subsequent five to seven years. What you can see at the bottom is a lot of gold. That's commodities. Commodities brought up the rear for several years running, and then somewhere in between are fixed-income assets. Actually, bonds performed exceptionally well over this 15-year period because of declining interest rates.

In 2022, though, it's been a little bit of a different story. We've had an upending of a lot of those norms that we had gotten used to. So, we had gotten used to a steady state of strong equity market returns, fairly strong bond returns. We had gotten used to not needing commodities in our portfolios. What we've seen so far this year is really a reversal of many of those trends, so we've seen stocks fall quite sharply, so down about 18% for U.S. stocks through mid-June. International stocks, while many market forecasters thought they were inexpensive coming into this year, have continued to kind of behave similarly to U.S. stocks. So, the MSCI EAFE Index, which is a developed-markets index, has fallen right in line with U.S. stocks. Emerging markets have also performed generally in line with U.S. stocks.

What's been really different about this particular bear market period is that bonds haven't cushioned the blow, and that's been a reversal of what we had seen in previous bear markets, whether that baby bear market that we had in March 2020 or the big bear market that we had at the end of the 2000s, from 2000 through 2009. What we've seen during this period is that bonds have not cushioned the blow. They've lost less than stocks, but they have certainly lost more than many of us bond investors expected them to.

And rising interest rates have been the main catalyst for the stock selloff as well as the bond selloff. Rising interest rates hurt bond prices because investors say, well, if higher interest rates are coming on line, forget these old bonds with the lower yields attached to them; I want the new higher yields. And stocks have sold off because oftentimes rising interest rates dampen investors' enthusiasm for the economy and in turn equities.

Growth stocks during this period have been especially hard-hit. So, this market selloff has not been equal opportunity. We've seen the growth column of our equity Morningstar Style Box be the epicenter of the losses, very steep losses among technology stocks, in particular. On the left-hand side of the style box, those are value stocks, and they've performed much, much better during this period. So, value stocks are often energy companies or often financial-services companies. Not only were these companies relatively undervalued coming into 2022, but the energy sector in particular has been a big beneficiary of the inflationary environment that we've seen so far this year.

And then, in the middle, we've seen, with the core or blend stocks, we've seen performance that falls somewhere between those two poles. So, the stocks are down, but they're not down quite as much as growth stocks. In that core or blend section of the style box, that's where we have consumer staples. Many healthcare stocks reside in that core column of the style box. So, losses all around but certainly much steeper losses in the growth column. Value stocks and value-oriented funds have held up much, much better.

In terms of where we've seen pockets of strength, there haven't been many, but I alluded to the fact that we've seen very strong price gains among the energy stocks. So, energy stocks tend to be a beneficiary of higher energy prices, higher commodity prices. Energy limited partnership-oriented companies and funds that invest in them have done very well during this period as well. Commodities-tracking investments have also done well during this period, and that's largely because energy purveyors are very dominant in commodities-tracking indexes. We've also seen some noncorrelated asset types come to life in 2022. So, what are called systematic trend funds or managed-futures funds have managed terrific gains so far this year. Equity market-neutral funds have also managed to stay in the black. Money market mutual funds haven't gained ground, but that actually puts them on the leaderboard in 2022. They have stayed just about flat for the year to date, but it makes them one of the few pockets of strength in this year's very tough market.

In terms of where we've seen weakness: all over the place. At the top of the heap though would be digital assets, so funds that invest in crypto currency, or certainly if you invest in cryptocurrency directly, you've seen losses in that portion of your portfolio. The technology sector has really led the way down during this market selloff. And then, all manner of growth funds have struggled during this period, mid-cap growth and small-cap growth especially, not just in the U.S. but also overseas. And we've also seen weakness in the consumer cyclical space. So, retailers and restaurants have also been struggling during this period; the thinking being that if inflation stays high, consumers will pull back on their spending in some of these areas.

This is the fixed-income style box. We looked at the equity style box and saw that the losses were very widely dispersed. The same is true for the fixed-income style box. Losses aren't as steep as what we've seen in the equity sector or in the equity area, but certainly there are losses across investors' fixed-income portfolios. I just want to describe what we're looking at because this style box is probably a bit less familiar to you than the equity style box. So, in the horizontal axis, we've got interest-rate sensitivity, so limited on the left-hand column, moderate in the middle, and extensive on the right-hand column. And you can see when you look at this style box that the losses have been quite concentrated in the investments with a lot of interest-rate sensitivity.

On the vertical axis, we've got credit quality. And you can see that lower-quality credits have performed a little bit worse than the higher-quality credits. But generally speaking, it's been interest-rate sensitivity that has been the main differentiator in performance. So, investments that take on a lot of interest-rate sensitivity, the reason they're vulnerable in an environment like this one is what I mentioned earlier: If interest rates are going up, investors say, well, I don't want to own this long-term bond that weds me to this very low yield for a long period of time. I want the opportunity to swap into these newer higher-yielding bonds, which is why long-term bonds are so very interest-rate sensitive. It's why most investors don't own long-term bonds because they tend to be very volatile and somewhat equitylike in their behavior.

When you're thinking about kind of the core type funds that populate investors' portfolios, they're in that middle square of the style box typically. So, they're taking on some interest-rate sensitivity, but they're typically in the intermediate range. They're taking on some credit risk, but they're typically in the medium credit-quality range. So, we've seen losses in the high single digits for investments like that for core type funds such as the ones that would track the Bloomberg Aggregate Index.

Let’s Talk Portfolio Strategy

So, let's talk about how this translates into how to think about your portfolio and its positioning. The starting point for conducting your own portfolio review is to get your arms around your portfolio's current asset allocation, and the best tool for that job, in my opinion, is to use our X-Ray tool, which you can use if you have your portfolio loaded on Morningstar.com, or you can simply use our Instant X-Ray tool to plug in your portfolio holdings and get a sense of how your asset allocation looks today. Our new portfolio tool in the Investor part of Morningstar.com, which is our former Premium part of Morningstar.com, plugs in a benchmark for you based on your portfolio's current positioning. You can override that and select your own benchmark for your portfolio's positioning.

The key point here is to have a benchmark for your portfolio's positioning. So, you can use one of our preloaded benchmarks. Or you can use what your advisor recommends your asset allocation should be. You can use a target-date fund for a quick and dirty lens into what your portfolio's asset allocation might look like. Or you can refer to some of the model portfolios that I've created from Morningstar.com and back into an appropriate asset allocation given your situation. So, the key thing is, you want to look at your portfolio's asset allocation today and then compare it to some reasonable benchmark given your life stage, given your proximity to spending your money, given your risk tolerance. You'd want to factor in all of these things, which is why it makes it difficult to issue one-size-fits-all recommendations about asset allocation. It really is very situation and individual dependent.

One good news story as you think about your portfolio's asset-class positioning is that thanks to this market weakness that we've had in the first half, stocks and bonds have actually gotten cheaper. So, I'll just describe what we're looking at on this slide. This is a slide that my colleagues in Morningstar Investment Management put together. It's meant to portray asset-class return forecasts for the next decade. This is through the end of March 2022. So, it incorporates some weakness that we had seen in the first quarter of this year but not the second-quarter weakness. And what you can see is that the equity return prospects have actually gotten better thanks to the market's volatility. So, the bright green bars that you see on this slide depict the change in their forecast from the end of 2021 when stocks were pretty richly valued to where they were at the end of the first quarter of 2022. My guess is because stocks continued to decline in the second quarter of 2022 that we will probably see even higher return expectations for stocks over the subsequent 10 years, which is what the team is forecasting on this slide.

I always say survey an array of these asset-class forecasts because it's helpful to get a gauge of what a number of different firms are saying. So, I typically will come out with a compendium of different asset-class return forecasts at the beginning of each year. I'll be revisiting those again at midyear 2022 because we've seen so much volatility. We've also seen bond prices fall, which we talked about earlier, and that too has translated into an elevated forecast for bond market returns over the next decade. So, I would say that this is a good-news story. As you think about repositioning your portfolio, think about determining whether any changes are in order. The good news is that both stocks and bonds are relatively more attractive than they were at the end of 2021.

When we look at this on a bottom-up basis, when we look at what our analysts' price/fair values might be telling us about whether the market is cheap or expensive, this is another good-news story and kind of corroborates what we saw on the previous slide. So, as of late June, which is as I'm recording this, we're seeing stocks trading in aggregate, so on their price/fair value basis, at a roughly 15%, 16% discount to fair value. You can see that that was also a switcheroo from the end of 2021, where stocks looked expensive to our analyst team on a bottom-up basis. Now we think they look relatively more attractive.

Just wanted to make a couple of quick comments on how our analysts arrive at these price/fair values. When they cover individual stocks, we task them with coming up with a fair value for that company based on its discounted cash flows. And so, we ask our analysts to determine whether stocks are looking cheap or expensive relative to those fair values. The price/fair value that you see depicted here is the aggregated price/fair values for all of the companies in our global coverage universe.

One interesting thing is that when we look at these price/fair values on a style box basis, when we try to figure out, well, does one part or the other of the style box look cheap or expensive to us today, what you can see is that this market selloff, because it has punished growth stocks most of all, has led to a market that looks somewhat fairly valued across the value, core and growth spectrum. So, I think that's an interesting takeaway. Investors may have been reticent to add to growth stocks, and they may still be, especially because we've seen so much volatility there, but our analysts are actually finding some opportunities among those beaten-down growth stocks. They're still finding opportunities in the value column as well, somewhat less so in that core column of the style box.

One interesting dimension as we think about the market and these price/fair values is that when we look at the end of 2021 and the price/fair values for that global coverage universe at the end of 2021, you can see that at that point our analysts thought that growth stocks were still looking a bit expensive and core stocks were also looking a bit expensive. Now, at midyear 2022, our analysts are actually finding bargains in that core area, and especially in that growth area, which has been especially hard-hit. So, that's something to think about as you're looking at your portfolio's intra-asset class positioning. If you have dedicated growth holdings, you may have found that they have declined quite a bit. They may decline further still, but our analysts are finding some opportunities. They're finding some values in that space.

The Impact That Rising Interest Rates Have on Investments

Now I want to talk about how rising interest rates affect your portfolio and how to think about them going forward. We showed this slide before. Bond yields have risen very quickly in a very short period of time over the past year, and that has driven a lot of the weakness that we've seen, certainly in the bond market, but also in the stock market. Your portfolio, if you have fixed-income assets, has no doubt already felt some of the pain, especially in the fixed-income area. Long-term bonds, we've talked about why they tend to be especially hard-hit in an environment like the current one. They have been hit the hardest. They're down about 20% for the year to date through mid- to late June. Long-term government-bond funds have been particularly hard-hit. And then, intermediate core bonds and what we call core-plus bond funds are down a little bit less, but still down double-digits for the year to date through mid- to late June. So, you've certainly seen weakness in your portfolio no matter what you have in terms of your fixed-income exposure. Short-term bonds have performed better. We saw on that style box slide, where we looked at bond market performance, their losses are in the realm of 3% or 4% for the year to date.

So, the Fed has done a good job along the way of telegraphing its impending moves of telling us about what it anticipates to do with interest-rate changes, what it's seeing in the economy. And so, I would say that much of what the Fed has said has already been priced in. The issue is that the Fed doesn't know necessarily what's ahead for inflation. It doesn't know whether the interest-rate changes that it has made so far and that it plans to make in the balance of this year, whether they will be sufficient to tamp down inflation. So, that's the risk as investors think about their fixed-income portfolios today, that even though very likely the Fed's near-term movements are priced into bond prices, if there is an unexpected spike in inflation, an unexpected spike in interest rates, we could see further weakness in our bond portfolios.

So, I've long enthused about this idea of running your fixed-income holdings through what's called a duration stress test, or what I think about as a duration stress test. And to do this you just need to find two data points for each of your fixed-income holdings, and this will be especially useful for your high-quality fixed-income holdings. So, you're finding your fund's duration, which you'll be able to find on Morningstar.com on the Portfolio tab for a fixed-income fund. Or you can find it on your investment provider's websites. You're finding duration. And you're also finding a number called SEC yield, which is Securities and Exchange Commission yield, and that's a recent snapshot of your fund's yield. So, you're finding those two numbers. You're subtracting the yield from the duration. And the amount that's left over is roughly the amount that you would expect to see that portfolio, that fund, lose in a one-year period in which interest rates rose by 1 percentage point. So, if we saw another 1-percentage-point increase in interest rates, you would likely see price declines at this general level. So, it's just a good ballpark estimate of what to expect if we see further interest-rate increases.

To use a simple example, a long-term government bond fund today has a very long duration of about 18 years and a yield of 3.0%, 3.5% today. So, what you can see, if you subtract that 3.0% yield, and the concept is that you get to keep your yield regardless of what happens with bond prices--if you subtract that 3.0%, 3.5% yield from that 18-year duration, that's a roughly 15% loss in that one-year period where we would see a rate increase by 1 percentage point. If you look at intermediate-term funds, which is what most of us own as our core fixed-income exposure, you see durations of about 6.0 years today. You see SEC yields in the neighborhood of 3.0% or even higher today. So, you can see with those core type funds they're actually going to be much less responsive in a negative way to interest-rate hikes, to further interest-rate hikes.

I like the idea of thinking about your fixed-income portfolio, deciding how much to allocate to short-term bonds, intermediate-term bonds, even cash by thinking about your time horizon, your anticipated spending horizon for your money. So, for your very near-term outlays, if you're retired and you have expenditures for the next couple of years that you'll be withdrawing from your portfolio, my bias would be just to keep that money in cash, not take any interest-rate-related risk. You may see its value get eaten up a little bit by inflation, but I think that generally speaking, you'd rather be safe than sorry with that portion of the portfolio. And then, if you have funds that you expect to spend in the next two to five years, say, there you might hold short-term bonds, which will have much less interest-rate sensitivity. They're not guaranteed in the same way that your cash holdings are. They will have a little bit of interest-rate-related volatility, but they will be much more stable than intermediate-term bonds.

And finally, I'd think about holding intermediate-term bonds for a time horizon of say five to 10 years. So, if I anticipate spending in five years or beyond that, there, I think, I can hold intermediate-term bonds with some confidence that over my particular time horizon until I need my money that my bonds will likely be in positive territory over that five-year period. Whether they will be in positive territory on a real or inflation-adjusted basis is another matter, but just from the standpoint of keeping principal stable, I think that that's a good way to think about segmenting your bond portfolio. Whether you hold long-term bonds in your portfolio as a matter of personal preference, I think that for many investors they're simply too volatile and too equitylike in terms of their behavior.

How to Build a Recession-Proof Portfolio

Now I want to talk about something that has only recently been in the headlines, which is the idea of recession or a softening economy, if not a full-blown recession. So, I want to talk about the fundamental underpinnings of recession, why we've been hearing more recessionary talk recently. And the key reason is that there is concern that if the Fed continues to act aggressively, which I think there is widespread agreement that they should act aggressively to stamp out inflation, they act too aggressively, they could overshoot and inadvertently push the economy into a recession or at least slow it down dramatically. So, that's the fundamental underpinning for why we've been hearing about recession more and more in terms of the headlines.

The quantitative expression of recession and why economists are thinking about recession is what's depicted here on the yield curve. So, I'll just describe what we're looking at starting with that green line on the screen. This was the yield curve through the end of the first quarter of 2021, and this is kind of a normally shaped yield curve. The basic idea is that the shorter-term investors, the ones who are owning two-year bonds and three-year bonds, they're getting paid less in terms of their yields for their bonds than the investors who are assuming all that interest-rate risk and holding 20- and 30-year bonds. Those people are getting paid more for the risk that they're assuming. One thing that we've been seeing this year in terms of this yield curve is a little bit of flattening. So, long-term bondholders are saying, well, you know what, you may not need to pay me quite as much because I think that yields will actually be going down. And this yield curve, the flattening yield curve, and certainly what's called an inverted yield curve where the short-term bondholders are actually getting paid more to hold their bonds than are the long-term bondholders, this has historically been a really good predictor of recessions. So, this is what has sent market watchers kind of chattering about potential recession, this concern that the yield curve is exhibiting this flattening pattern, which is indicating that some bond market participants are expecting some economic weakness, they're expecting that before long the Fed actually may be stepping off the breaks with respect to interest rates, they may be lowering interest rates, which would make those long-term bonds, even though their yields aren't high in absolute terms, that would make them worth more than newer bonds that might come on line with lower yields attached to them. So, just food for thought. Nothing to get carried away with respect to your portfolio, but something to keep in the back of your mind as you're thinking about repositioning.

And the really tricky part of this recessionary talk is that the categories, the hardest-hit categories, some of them, especially in the fixed-income space, are the things that you want in your portfolio in a recessionary environment. So, high-quality bonds tend to be very, very good performers in recessionary environments, in part because recessionary environments typically spur a flight to quality, and high-quality bonds are one of the key high-quality investments that investors look to, but also because interest rates often decline in recessionary periods, which makes high-quality bonds worth more. It elevates high-quality bond prices. So, I think a key thing to think about as you're thinking about your portfolio is, even as you might be inclined to throw bonds overboard given how poor their performance has been in the first half of 2022, they tend to be good ballast for equities in some sort of an economic weakness or recessionary environment. So, I would say, beware of drastic all-or-nothing measures with respect to your fixed-income exposure in your portfolio. You probably want to maintain some exposure to high-quality bonds to protect you in a recessionary scenario.

On the equity side, this is another interesting and perhaps a little bit counterintuitive thing. Some of the areas that have held up best in 2022--so commodities, energy investments--could actually underperform in a period of slack economic growth, which I think is an argument for not loading the boat with them even though their performance has been really great, and they've probably held your portfolio aloft to the extent that you've had them in your portfolio. You want to be careful about overdoing them because of their sensitivity to the economic environment.

On the other hand, when we think about categories that tend to hold up well in recessionary environments, healthcare stocks tend to do well in such a period. Consumer staples stocks also hold up well. Really, anything that consumers will continue to buy regardless of what's going on in the economy, so that's paper towels, that's drugs that people need to take, those tend to be quite recession-resistant. They are things that you'd want to maintain ongoing exposure in your portfolio to.

The Impact of Inflation on Investments

Now I want to talk about inflation. Inflation has certainly been hard to ignore. We've seen inflation rise really sharply over the past year, and this has been a real turnabout. We talked earlier on about how the turnabout in interest rates has upended what had been kind of a long-standing regime. The selloff in stocks has upended what had been a really comfy period for equityholders. Similar with inflation. Where I think many of us had gotten somewhat complacent about inflation; it had sort of plotted along at kind of a 2%, even sub-2% sort of zone for many years. Recently, as you all know, the inflation rate has jumped up very dramatically into the 8% range as of its most recent reading. So, this complicates planning. I would argue that it particularly complicates planning for older adults who are drawing from their portfolios. So, the reason that it's worrisome for older adults is that older adults typically are drawing a percentage of their living expenses from their portfolios and they're also typically holding safer investments in their portfolios. They may hold some stocks, but they are also holding some fixed-rate investments. They're holding bonds; they're holding cash. And unless you go out of your way to add inflation-protected bonds, the payments you receive from those fixed-rate investments are not automatically inflation adjusted.

So, I think it's worthwhile to think about your personal inflation situation as a starting point for thinking about how worried you should be about inflation. So, I like the idea of looking on your personal spending, looking at your pattern over the past year or the past several years to think about what your personal spending rate is and in turn your personal inflation rate. I've written about this topic before. I created a little calculator to plug in your own spending and your own inflation calculation to come out with a customized inflation rate. And I also always have to credit this concept to Jason Zweig, because probably 10 years ago, he wrote about the importance of not just taking CPI and running with it, but instead using kind of a personalized inflation rate. So, I think, that's the starting point for this process, for customizing your inflation rate. You may find that your personal inflation rate is higher than CPI, but if you're someone who doesn't drive a lot, for example, you may find that your personal inflation rate is actually a little bit lower. So, run the numbers on that.

And then, the next step is to look at your sources of cash flow, your sources of income. Some people find themselves in the position of being at least somewhat insulated against inflation. A good example would be people who are earning paychecks and eligible for cost-of-living adjustments in those paychecks. Their increases may not make them whole with respect to inflation. So, if inflation is up 9% this year, not everyone's getting a 9% raise this year. But generally speaking, employers have been attuned to the fact that inflation has been higher, and they have been giving employees a raise. People who are on Social Security are also getting an adjustment. Social Security recipients received a 6% inflation adjustment for 2022. So, for retirees who are taking a big share of their income needs from Social Security, they're at least somewhat protected from the standpoint of inflation. And then, people who receive government pensions typically receive nice cost-of-living adjustments to account for inflation. These are the groups who are at least somewhat insulated from inflation.

In terms of who is not insulated, I mentioned people who are earning interest who have a lot of their portfolios in fixed-rate investments, who have a lot of their assets in cash, who have a lot of their assets in bonds, those interest-rate payments that you receive from the bonds are not automatically inflation adjusted. If you just hunker down in a money market fund, for example, for your whole retirement account when inflation flares up, as it has recently, it will eat a hole in the payouts from your portfolio. Private corporate pensions aren't typically inflation adjusted, either. So, if you're someone when you look at your retirement plan, a big share of your income is going to be coming from a pension, well, ask some questions about whether any inflation adjustments are in play. Oftentimes, that's not the case. So, you'd want to make sure that you're taking steps to insulate your plan against inflation.

How do we think about inflation protection at the portfolio level? Well, when we think about the categories that are direct hedges against inflation, that would be inflation-protected bonds, so Treasury Inflation-Protected Securities, or TIPS, would be one category. I Bonds would be another category. They are relatives. They tend to work in a similar way. Both are bonds, so they issue interest, and they also provide you an inflation adjustment to help you keep pace with inflation. So, I was talking about how nominal bonds and certainly cash investments are very, very vulnerable to inflation. TIPS and I Bonds have a built-in hedge to help you keep pace with inflation. I Bonds have issued very attractive yields. The new I Bonds coming to market have very attractive yields, in part because of the inflation-adjustment piece. One key thing to keep in mind though is that purchase constraints limit how much people can put into I Bonds. So, even though they're a great component of investors' portfolios, you may be curtailed in how much you can put in, how much of your portfolio you can put into them. So, you may want to augment that position with a position in Treasury Inflation-Protected Securities or a fund that invests in them. My preference is for the shorter-term TIPS funds because they tend not to capture a lot of that interest-rate-related volatility that comes along with intermediate-term TIPS.

Stocks are another thing to think about when you're thinking about how to make sure that your portfolio is inflation protected. I want to clarify that stocks are by no means a direct hedge against inflation. So, we have a lot of inflation so far in 2022. Stocks are down. So, there's not that one-to-one offsetting effect with stocks. But over long periods of time, stocks have tended to outearn the inflation rate. So, they've tended to help you keep pace with or perhaps earn higher returns than the inflation rate.

Then a few niche categories that I would mention in the context of inflation. Real estate, certainly real estate investment trusts. The companies that own these properties are typically able to push through rent increases in inflationary periods, and we've certainly seen higher rents come on line in many contexts within the real estate space. So, real estate is generally considered a decent inflation hedge. That's why I think it makes sense as a component of most investors' portfolios. If you own a total stock market index or something like that, you're certainly getting a little bit of real estate equity exposure there.

Commodities have performed very, very well in inflationary periods where we've seen them come on strong this year. Whether you want to add to them now, if you haven't had them in your portfolios, I think is an open question, because the risk is that if the economy cools, if inflation cools, investors' appetite for commodities could cool as well, and commodities have just been incredibly volatile over time.

Bank-loan investments, sometimes called floating-rate investments, can also be a nice tool to think about adding to your portfolio. They have generally performed reasonably well, certainly better than high-quality bonds during this period. High-yield bonds are another category to consider as a component of your fixed-income portfolio. I wouldn't hold either of these investments as kind of the main course within my fixed-income portfolio. I'd own them as sort of aggressive kickers within my fixed-income portfolio. But, in general, they will tend to hold up better than high-quality bonds in an inflationary environment.

Tax To-Dos: Tax-Efficient Investing

Now I want to close by talking a little bit about how to find silver linings in this market. And I think one of the key things you can do is to look at whether you can improve your tax positioning a little bit. If you have taxable holdings, so if you have holdings in your nonretirement account, you want to look at whether you have any positions that are trading below your cost basis, so they've declined in value since you purchased them. If you do, you can sell them and realize a loss. And the value of doing that tax-loss selling is that if you realize a loss, you can use those losses to offset capital gains elsewhere in your portfolio. And if you don't have any capital gains, you can use those losses to offset up to $3,000 in ordinary income. So, it's a really attractive strategy, especially for newly purchased shares. If you don't need to use your losses, or if you're not able to use your losses in this year, in 2022, you'll be able to carry them forward into future years. So, you can actually be strategic about this. If this looks like it's not going to be a high tax year, but you expect that 2024 might be, for example, you'll be able to use the tax losses in that year further into the future.

I mentioned that tax-loss selling will tend to be the most useful for the recently purchased securities. So, if you have securities that have been in your portfolio for a decade or more and you haven't made any recent purchases, you probably have a gain over your time horizon because stocks have performed well, bonds have performed well. But if you've purchased securities recently, so for example, if you've been making regular ongoing purchases, those are the holdings that will tend to be particularly ripe for the picking in terms of tax-loss selling. So, if you purchased shares in 2021, for example, even though it was a great equity market, those shares may have declined in price since your purchase price. So, you can use different cost-basis elections for categorizing your purchases and sales. The method that you would want to use if you're going to pick off specific shares of your portfolio would be specific-share identification. So, that means that you effectively cherry-pick the downtrodden shares, so the ones that have depreciated since you purchased them.

One thing you want to keep in mind is that if you are a fundholder and you've already used the averaging method for calculating your cost basis, you can't switch into the specific-share-identification method. So, if you've sold securities before and you've used the averaging method, it's not OK to use this specific-share-identification method later. So, check your cost-basis elections. Check what you have on record with your investment provider. Check what you've been doing in the past.

One concept that is important to discuss in the context of tax-loss selling is what's called the "wash sale" rule. And that means that if you rebuy securities within 30 days of having sold them, you will essentially negate any tax loss that you have realized. So, you want to be careful about that. You want to be careful about selling a security and rebuying exactly the same security or a security that the IRS considers a substantially identical security. So, this would be, for example, if you want to sell an index fund, a traditional index fund, and swap into an exchange-traded fund that tracks the same index. That would not fly with respect to the wash sale rule. So, keep that in mind as you think about replacing those positions where you've captured the tax loss. Just be mindful of the wash sale rule that you either need to wait 30 days to purchase exactly the same security or you need to purchase something that's different, meaningfully different in order for that tax loss to count.

I also wanted to talk a little bit about IRA conversions. So, tax-loss selling applies to taxable accounts. IRA conversions apply to your IRAs. And the basic idea with conversion is that you are converting traditional IRA assets to Roth. The benefit of doing that is that Roth IRAs do not have required minimum distributions, in contrast with traditional IRAs. And the big benefit of putting money into the Roth IRA column is that the withdrawals, qualified withdrawals, from a Roth IRA tax-free. So, that's the reason that people like to consider IRA conversions.

When you're looking at whether an IRA conversion is beneficial, you want to be thinking about two key things. First, you want to think about your own tax position. Generally speaking, these conversions are more beneficial in environments in which you expect to be in a low tax year. So, you find yourself in a year where you have a lot of deductions, for example, those can be great years to engineer conversions. Similarly, people in the postretirement years often find themselves with fairly low incomes relative to what they had when they were working. Those are good times to consider conversions. So, you're thinking about your personal situation, thinking about whether you're in a low tax year, and then you're also thinking about your portfolio and whether your holdings have declined. And I would say that for most of us our holdings have declined in 2022. So, a conversion may be more beneficial in this year where stocks and bonds have sold off than would have been the case in 2021, for example, when everything was way up.

So, get some tax advice on this. The name of the game if you are doing IRA conversions is try to figure out how much you can convert in a given year to avoid pushing yourself into a higher tax bracket. If you're not comfortable running through that calculation, get some advice, either from a financial advisor or a tax advisor who can help you decide whether to proceed. A series of conversions will make sense in a lot of situations. So, rather than doing one large conversion in a single year, you may find that if you space out conversions, that will lessen the taxes due on that conversion.

So, that ends my presentation. I hope this has provided you with some good food for thought as you think about positioning your portfolio at midyear, thinking about what has gone on in the market over the first half. Thank you so much for watching.

I'm Christine Benz from Morningstar.com.

More on these topics from Christine Benz: Is It Time to Recession-Proof Your Investment Portfolio? 5 Things to Do in a Bear Market Cheap(er) Roth Conversions Are a Silver Lining in a Falling Market What Rising Yields Mean for Your Retirement It's Time for Tax-Loss Selling How Much Cash Should You Have on Hand Today?