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A Year-End Portfolio Review in 6 Easy Steps

Morningstar logo Morningstar 12/19/2018 Christine Benz

It has been an odd year for investors so far. Interest-rate worries roiled stocks and bonds early in the year, followed by a period of relative tranquility in year's middle two quarters. Then came October's tariff worries, which prompted the U.S equity market tumble to 7% that month. Certain market segments, especially technology and energy stocks, fell further still. That volatility has persisted into December, too.

If you're a disciplined investor who has been spooked by the recent market volatility, you can use an annual portfolio review as a way to check up on your portfolio--and potentially make some changes--within the context of your well-thought-out plan. I like the idea of thinking of your annual portfolio review as an inverted pyramid, with the most important jobs on the top and the least important ones at the bottom. That way, if you run out of time and need to give something short shrift, you'll have attended to the most important considerations first.

Here are the key steps to take.

Step 1: Conduct a 'wellness check.'

Begin your portfolio checkup by answering the question: "How am I doing on my progress to my goals?"

For accumulators, that means checking up 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 2018: 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 own salaries (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. If your 2018 savings rate will fall short of what you'd like it to be, take a closer look at your household budget for spots to economize. In addition to assessing 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--all of your portfolio withdrawals for this year, 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.)

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.

Despite the fact that stocks have encountered tough sledding in 2018, many investors' portfolios are still heavy on equities. That's not a huge deal for younger investors with many years until retirement, but 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: Check the adequacy of liquid reserves.

In addition to checking up on your portfolio's long-term asset allocations, your year-end portfolio review 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 essential; 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. 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 check up on where you're holding that money. A happy side effect of rising interest rates is that cash yields have trended up to 2% or more. If you're settling for substantially less than that, you're leaving money on the table. 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 sub-allocations and troubleshoot other portfolio-level risk factors.

For a few years there, U.S. stocks of every persuasion seemed to move in lockstep: Value stocks' performance was in line with growth names, while small caps' returns were in line with large. Not so in 2017, or 2018 thus far. Even though technology stocks swooned in the fourth quarter, domestic growth stocks and funds have still outperformed value names by a wide margin. Check your portfolio's 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 24% in each of the large-cap squares, 6% apiece in the mid-cap boxes, and 3% in each of the mid-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.

On the bond side, review your positioning to ensure that your bond portfolio will deliver ballast when you need it. Thus far in 2018, high-quality short- and intermediate-term funds have done a good job of holding their ground even as longer-term and more specialized bond types, like emerging markets bonds, have gyrated. 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 5: Review holdings.

In addition to checking up on allocations and sub-allocations, take a closer look at individual holdings. Scanning Morningstar's qualitative ratings--star ratings for stocks and Medalist ratings for mutual funds and ETFs--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 6: Attend to tax matters.

Year-end is also your deadline for several tax-related to-dos, some of which touch your portfolio. If you're still in accumulation mode, review how much you're contributing to each of the tax-sheltered account types that are available to you: IRAs, company retirement plans, and health savings accounts. Contribution limits for 401(k)s, 403(b)s, and 457 plans will be increasing in 2019, to $19,000 for workers under age 50 and $25,000 for workers who are 50-plus. The IRA contribution limit is also going up, to $6,000 for investors under age 50 and $7,000 for investors who are over 50. 

In addition, retirees must take required minimum distributions from tax-deferred accounts before year-end. I'm a big believer in taking a surgical approach to RMDs, using those withdrawals to correct portfolio problem spots. This article takes a closer look at tying in RMDs with rebalancing. Charitably inclined investors who are subject to RMDs should take advantage of what's called a qualified charitable distribution.

With market volatility comes increased opportunities for tax-loss selling, especially in foreign stocks and funds and energy, natural resources, and precious metals stocks and funds. You can use those losses to offset gains elsewhere in your portfolio, as discussed here. 

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