1. Check to see if your portfolio needs rebalancing.
While periodically buying and selling holdings to bring your portfolio’s asset allocation in line with your target levels doesn’t usually enhance returns, rebalancing is a critical step for keeping a portfolio’s risk level in check. As market segments move in and out of favor, some areas of your portfolio might drift far above your original targets, while other areas might end up too low. If it’s been a few years since you rebalanced your portfolio, you’ll probably find that you’re overweight on domestic stocks (which have outperformed in eight of the past 10 calendar years, including the year to date in 2023) and light on international stocks. Similarly, as growth stocks returned to the fore in 2023, your portfolio might be overweight on growth stocks and light on value.
2. Consider adding to your portfolio’s bond allocation.
Bond investors have had a rough couple of years. The bond market suffered its worst calendar-year performance ever in 2022, when a series of aggressive interest-rate hikes led to a 13% drop in the Morningstar US Core Bond Index. Bonds fared better in 2023 but still suffered losses during the second and third quarters of the year.
But after this series of events, bonds have much better prospects for future performance. That’s because bonds are now offering significantly better yields than they did a couple of years ago. The 10-year Treasury bond offered a nominal yield of 3.9% as of Dec. 26, 2023. That’s down slightly from earlier this year but still higher than yields that prevailed during most of the period following the global financial crisis. The starting yield on bonds is a strong indication of future returns, so higher bond yields suggest that future returns should be better than those in the recent past. Bond yields are not only attractive in historical terms but also relative to stocks. While earnings yields on stocks exceeded those on the 10-year Treasury bond yield from 2009 through 2022, the spread between stocks and bonds is now much smaller.
There are some caveats, though. Even though the prospects for future bond returns look decent, bonds aren’t likely to keep pace with stocks over longer periods. If you’re looking to save up for a long-term goal such as retirement, you’ll want to make sure your portfolio also includes a healthy dose of stocks.
3. Make sure you’re getting a competitive yield on your cash holdings.
During the long period of near-zero interest rates, there wasn’t much need to shop around for interest rates on cash and other short-term holdings. Yields were low no matter what. But now that yields on the three-month Treasury bill are hovering around 5.4% (as of Dec. 26, 2023), it pays to make sure you’re getting a competitive interest rate. Traditional brick-and-mortar banks offer some of the worst payouts, with annual percentage yields averaging about 0.5% as of Dec. 18, 2023. It’s not difficult to find significantly better yields on high-yield savings accounts; money market funds; certificates of deposit; or Treasury bills, purchased via Treasury Direct.
If you don’t need immediate liquidity from your cash holdings, consider building a ladder of CDs or Treasury bills to lock in higher rates over a slightly longer period.
4. But don’t overdo it on cash.
As mentioned in the previous section, cash yields have been unusually generous lately. Yields on the three-month Treasury bill have been as high as 5.5% so far in 2023—their highest level since December 2000. That’s not only decent in absolute terms but also well ahead of inflation, which has been running at about 3.1% year over year based on the most recent data reported on Dec. 12, 2023. The attractive yield on cash has led to a flood of cash in money market funds, totaling more than $1 trillion for the 12-month period through Nov. 30, 2023.
But as I wrote in a recent article, loading up on cash can be too much of a good thing. It makes sense for most investors to hold some liquid reserves to cover emergencies and short-term spending needs. Retirees may want to hold a bigger chunk of cash to cover planned portfolio withdrawals for at least two to three years. For other investors, however, cash isn’t the best way to build long-term wealth.
5. Don’t get too complacent about inflation.
After a series of encouraging inflation reports, the market has been heartened to see evidence that inflation is finally under control. The current consensus forecast is for inflation to ease to about 2.4% by the end of 2024.
That would undoubtedly be a great outcome, but there are a few things to keep in mind. First, even 2.4% is still higher than the Fed’s long-term target of 2.0%. And even moderate inflation represents a significant loss of value over time: A 2.0% annual inflation translates into nearly a 22% loss of purchasing power over 10 years. Second, the market’s current inflation outlook could prove overly optimistic. Unemployment remains well below longer-term averages, while huge amounts of pandemic-driven spending have led to record budget deficits.
Most investors will therefore probably want to maintain some level of inflation protection, such as Treasury Inflation-Protected Securities, I Bonds, or a small stake in commodities.
6. Consider adding some exposure to small-cap stocks.
Bigger has been better for most of the past decade. While smaller-cap stocks pulled ahead in 2022, mega-cap stocks—especially the “Magnificent Seven” (Alphabet GOOGL, Amazon.com AMZN, Apple AAPL, Meta Platforms META, Microsoft MSFT, Nvidia NVDA, and Tesla TSLA) stocks that have dominated the market—have outperformed in eight of the past 10 calendar years. For the year to date through Dec. 21, 2023, for example, the Morningstar US Large Cap Index posted a gain of about 29%—about 9 percentage points higher than Morningstar’s small-cap benchmark.
As a result, valuations on small-cap stocks are now looking significantly more attractive. While large-cap stocks look fairly valued overall, the average small-cap stock was trading at a 19% discount to fair value based on Morningstar’s analyst estimates as of Dec. 13, 2023. Granted, smaller companies tend to be less profitable and have weaker balance sheets than bigger, more-established companies. As a result, they could fall behind if the U.S. economy weakens. Still, long-term investors may want to consider adding a modest stake in smaller-cap issues, partly as a counterweight to the large, growth-oriented tech stocks that now dominate most broad market indexes.
The author or authors own shares in one or more securities mentioned in this article. Find out about Morningstar’s editorial policies.