Portfolio Housekeeping, Part 2

Dear Readers —
This week we wrap up our annual portfolio housekeeping project.

When last we met you were knee deep in discovering how your current portfolio is allocated according to 1) asset class — stocks, bonds, cash; 2) geographic breakdown — international, domestic; 3) and by market capitalization — large, medium, and small company stocks.

You should also have a clear sense of whether your portfolio is more heavily weighted toward certain industries than a broad-based index such as the S&P 500. All of this is possible thanks to free tools available at http://www.morningstar.com. To see how to get this far, review last week’s instructions.

But, you say, what good is knowing all this? What does it tell you about where you stand in terms of meeting your retirement goal? And how much income will your nest egg actually provide? What’s the risk you’ll run out of money?

First of all, I’m not suggesting that your portfolio needs to mirror the S&P 500 index in terms of the percentage in each industry. In fact, some people would argue that you should compare your sector breakdown to an even broader market index — the Wilshire 5000, which includes small and medium-sized firms as well as the large companies that make up the S&P 500.

As I said last week, the point is if you are over-weighting certain sectors — either in terms of industry or mark cap (company size) — you should be aware of this. Surprises are fine for birthdays; they are usually not a good idea when it comes to your investments.

So keep this in mind: concentration is the opposite of diversification. If you’re right, you could make a lot of money. However, if you’re wrong, you only have to go back to March 2000 to recall how badly you could get clobbered.

You can get a good idea of how your portfolio stacks up against the broader market by comparing it to the Vanguard Total Stock Index fund. (Near the top of the Morningstar page click on "funds" and then enter "VTSMX" into the search box.)

What if you decide that you have more allocated to a particular asset class or industry than you’re comfortable with? In that case, Christine Benz, Associate Director of Fund Analysis at Morningstar, says "You have to figure out what you need to do to get this in line."

For instance, let’s say you’re satisfied with your stock holdings but notice that the Style Box Diversification breakdown indicates your portfolio is extremely sensitive to changes in interest rates. In light of the fact that the Federal Reserve has made it clear it intends to continue raising interest rates, you might want to reduce the amount of long term bonds you own. (Bond prices move in the opposite direction of interest rates, so an increase in rates results in a decline in bond prices and the more time a bond has until it matures, the more pronounced this is.)

To find out what’s contributing to your portfolio’s interest rate risk this you have to take a closer look at what’s inside your individual mutual funds. You do this by clicking on "funds" near the top of the page and typing in the symbol for your bond funds. Don’t overlook funds (often called "balanced funds") that own both stocks and bonds.

Now you’ve got a choice: you can return to the X-ray page and adjust the amounts you have invested in your various funds. Then check the Style Box breakdown again to see how this has affected the interest rate sensitivity of your portfolio. If that doesn’t get you where you want to be, try completely changing one of the bond funds you own. What other choices does your company retirement plan offer? What about your spouse’s plan?

Or, from the drop down menu on the left side of the page, scroll down to "Portfolio Tools" and select "Portfolio Allocator." In 4 steps, Morningstar will help you pick the mutual funds that will align your portfolio with your target allocation.

Let’s say you realize you’ve got too much sitting in cash and bonds and not enough invested in foreign investments. Enter the target weightings you’d like to have in these categories.

Next, identify the profile you want for the bond portion of your portfolio by choosing a risk level and credit quality. Finally, tell the program which funds you absolutely don’t want to sell and ask it to come up with a new portfolio for you.

If the suggested portfolio contains funds that aren’t offered through your retirement plan, you could use your IRA (another type of tax-deferred account) as the place to hold, say, an intermediate-term bond fund. You could also search Morningstar’s site for the names of similar funds.

It could take a little time to get to where you want to be, so be patient. According to Benz, "You probably won’t get it right on your first try, but I’d urge people to tinker with the mix a bit."

At last we get to where the rubber meets the road: what’s the probability your chosen asset allocation will generate the next egg you want by the time you retire?

For this, we’re going to use a Morningstar tool called "Asset Allocator." It’s only available if you subscribe to their monthly service. But they offer a free 14-day trial.

Taking advantage of this will graphically illustrate what your portfolio is likely to be worth based on the timeframe you’ve chosen.

Though the graph is the first thing that will catch your eye, the critical information is just to the left of it: here you’ll find the probability of achieving the nest egg you want. If it looks as if you’re going to fall short, try changing the asset allocation by moving the dial (lower left). Or, enter the dollar amount you want to have by the time you retire and allow the software to come up with a new mix for your portfolio. "You may end up with an asset allocation that isn’t comfortable all the time," says Benz. "Risk tolerance may need to take a back seat to making sure you have enough for retirement."

If that’s not acceptable, consider reducing the amount of money you wish to have. What would happen if you worked a few years longer or saved more on a monthly basis? This tool will instantly show you how a change in one area impacts all the other variables.

Now for the final test: how much income can you expect your portfolio to generate and for how long? This means we have to fast-forward to the future. Assume you have managed to accumulate the next egg you think you’ll need and enter this in the box labeled "Portfolio Value." (If you’re already retired, just enter the value of your current portfolio.)

Since you’re no longer saving money each month, make sure there is a zero in this box. Under "Financial Goal" enter the amount of income you’d like your investments to generate and, to be on the safe side, plan on withdrawing this for at least 30 years. There’s one hitch: in order for your income to keep pace with inflation, you’d want it to increase each year and this program doesn’t incorporate this concept. It assumes you withdraw the same dollar amount each year.

In other words, say you want your nest egg to provide $30,000 in your first year of retirement. If inflation runs 3 percent that year, in your second year of retirement you’d want to withdraw $30,900. The additional $900 covers the increased cost of living so that your lifestyle doesn’t decline. Over time this adds up. If you had a 3 percent inflation rate throughout your retirement, by the 24th year, you’d need TWICE the income you withdrew the first year just to pay for the same standard of living. Even though the Asset Allocator does not factor this in, it’s still a useful tool for approximating how long your money will last. (One way to get around this shortcoming would be to wait, say, 5 years and re-visit the program. Then you can simply enter your own inflation-adjusted dollar amount in the "Financial Goal" box.)

Keep in mind that, once retired, you will probably feel more comfortable with a more stable, income-oriented mix of investments in your portfolio. Play with the asset allocation dial. Keep an eye on the numbers to the left of the graph. What if your conservative retirement portfolio only has a 50% chance of providing the income you’ll need?

Again, here’s where you’ve got choices to make: 1) plan to save more so your next egg is larger; 2) accept a higher level of risk in your retirement portfolio by increasing your exposure to stocks; 3) lower your expectations about the lifestyle you can afford by reducing your annual income.

The point is, it’s in your hands! Regardless what changes are in store for Social Security, you can have a more secure retirement.

If you’d like to receive a copy of Morningstar’s Find the Right Mutual Funds, send me an email that describes why you think you need this book and how you’d use it. We only have a limited number to give away. I promise to read every submission, but long-winded letters will hurt rather than help your cause.

All the best,


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The views expressed in this article are those of Ms. Buckner or the individual commentator. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.