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Your year-end portfolio review

Christine Benz  |  10 Dec 2021Text size  Decrease  Increase  |  
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As 2021 winds down, investors can look back on yet another excellent year. While investors have had plenty to worry about - especially inflation and the delta and omicron variants of the coronavirus - that hasn't stopped US stocks from posting a tremendous rally. Australian stocks are poised to end the year with respectable gains. 

If you're a disciplined investor, 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. After all, even if you haven't actively made changes to your portfolio mix, the contents of your portfolio may have shifted.

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 2021: 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 education funding for children or a home down payment. If your 2021 savings rate will fall short of what you'd like it to be, take a closer look at your household budget for spots to economise.

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 if you're just embarking on retirement, our recent research on withdrawal rates should provide good food for thought.

Step 2: Assess Your Asset Allocation

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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 Premium --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, the Morningstar Lifetime Allocation Indexes are useful benchmarking tools. High-quality target-date series such as BlackRock LifePath Index can serve a similar role for benchmarking asset allocation; focus on the vintage that roughly matches your anticipated retirement date. My model portfolios can also help with the benchmarking process.

Given stocks' very robust performance in 2021, many investors' portfolios are heavy on equities. That's not a huge deal for younger investors with many years until retirement, but it 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, derisking 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.

More on this topic: Year-end portfolio rebalancing: What you need to know

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. Online high interest savings accounts are usually among the highest-yielding.

Step 4: Assess Suballocations and Troubleshoot Other Portfolio-Level Risk Factors

While value stocks have managed solid gains thus far in 2021, growth stocks have trumped value over longer time periods. Check your portfolio's Morningstar Style Box exposure in X-Ray to see if it's tilting disproportionately to growth names. While you're at it, check up on your sector positioning; X-Ray showcases your own portfolio's sector exposures alongside an index for benchmarking.

On the bond side, review your positioning to ensure that your bond portfolio will deliver ballast when you need it. Yes, high-quality bonds and bond funds often take a price hit when interest rates rise, but they have historically done a good job of holding their ground when stocks fall. 

Step 5: Gauge Inflation Protection

Inflation was a nonissue for the better part of the past decade, but it's been on the front burner more recently. If you're still working, eligible for cost-of-living adjustments to your salary, and have ample stock exposure in your portfolio, there's no pressing reason to add in a lot of inflation protection. On the other hand, retirees with healthy shares of their portfolios in fixed-rate investments are more vulnerable, in that inflation gobbles up the purchasing power of their meager yields. I like to group inflation-defending investments into a few key categories: broad basket (TIPS), more narrowly focused (commodities, real estate), and what I call "inflation beaters" (stocks).

More on this topic: What rising inflation means for Australian investors

Step 6: Review Holdings

In addition to checking up on allocations and suballocations, take a closer look at individual holdings. Scanning Morningstar's qualitative ratings--star ratings for stocks and Morningstar Medalist ratings for managed 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.

is Morningstar's director of personal finance.

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