Some investors have gotten complacent amid the equity runup, but it's a good time to revisit portfolio allocations.
By Christine Benz | 08-09-17 | 12:00 AM | Email Article

This year has been a remarkably placid one for investors thus far, but saber rattling between the United States and North Korea has some pundits discussing whether geopolitical worries could be the catalyst for the long-anticipated market sell-off.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

As always, it's difficult (if not impossible) to say what stocks will do in the near term. Yet the length and breadth of the current rally in higher-risk assets, especially stocks and categories like junk bonds, make it a good time to revisit your portfolio's allocations if you haven't done so recently. Well-meaning investors who are trying to do the right thing by not being too hands-on with their portfolios can end up, inadvertently, with an investment mix that's too risky, simply because they've been letting their winners ride.

If you haven't looked at your portfolio recently, you can conduct a quick stress test by assessing the following.

1. Check up on your baseline stock/bond mix.
In strong markets like the bull market that has prevailed since early 2009, most investors tend to leave well enough alone. But if you haven't reviewed your portfolio's allocations recently, use the market volatility as an impetus to do so. A hands-off portfolio that was 60% equity/40% bond in early 2009, for example, would be more than 80% equity today--and meanwhile you're eight years older.

That means rebalancing is in order in many situations. As discussed here, rebalancing can help align your portfolios' allocations with your risk capacity, which is your ability to withstand losses without having to alter your plans. Young investors--and here I mean anyone under age 50--have high risk capacities in most cases. With many more years on the job, they won't likely need to tap their investment portfolios any time soon. But investors getting close to retirement will want to put more safe investments in place, to help reduce the possibility of needing to raid their long-term assets while they're down. Their risk capacities are lower.

Morningstar's Instant X-Ray tool can help you survey where your portfolio's total allocations stand today--its baseline stock/bond mix, as well as its allocations to various investment styles. You can then compare those allocations to some benchmark--either one provided by your financial advisor, Morningstar's Lifetime Allocation Indexes, or a good target-date fund like the ones from Vanguard or BlackRock. This article includes more details on rebalancing, including the need to take tax consequences into account if you're selling highly appreciated stocks.

2. Assess liquid reserves.
In addition to checking your portfolio's long-term stock/bond allocation, it's also a good time to check up on your allocation to liquid assets (i.e., cash): The last thing you want to have to do is raid long-term assets after they've dropped because you need to meet near-term living expenses or expenditures like next semester's college tuition bill.

For retirees, I'm a big believer in holding one to two years' living expenses in liquid reserves, alongside a long-term portfolio composed of stocks and bonds. This article outlines the bucket approach to retirement portfolio management, a key virtue of which is helping tide you through tough markets without having to raid your long-term assets. For people who are still earning a salary, holding anywhere from three months to one year worth of living expenses (or even more) in liquid reserves can make for a solid emergency fund. If you have lumpy, ongoing expenses you'll have to meet within the next year, such as the aforementioned tuition bill or your property taxes, you'll want to earmark additional assets for those, apart from your emergency fund.

Opportunistic investors, meanwhile, may want to set aside some liquid assets in case they'd like to deploy cash at a later date, if and when stocks fall. (No, I don't have a crystal ball, but it's a safe bet that value-minded buyers will have better buying opportunities at some point in the future than they do today.)

X-Ray won't help you in assessing your liquid reserves, because its cash allocation will reflect residual cash holdings in your mutual funds, and you can't extract that type of cash in a pinch. Instead, you'll need to hand-tally your various pools of cash. If you've gotten lazy about wringing any income from your cash holdings, shop around; online savings banks are, in many cases, yielding more than 1% today.

3. Dig into suballocations.
Your portfolio's allocations to the major asset classes will be the key determinants of how it behaves. But before you conduct any rebalancing, check up on your portfolio's suballocations: its exposures to various sectors, investment styles, and geographies, as depicted through X-Ray. If you have determined it's time to trim back your portfolio's equity exposure, you'll want to concentrate on the portions of your portfolio that have enjoyed the most dramatic appreciation. So far in 2017, high-octane growth stocks from the technology sector have gained far more than everything else, so many investors' portfolios are likely listing to the right (growth) side of the style box. International stocks, especially emerging-markets equities, have also enjoyed a long-overdue recovery; emerging-markets names are often the first to tumble in any sort of geopolitical crisis.

4. Make sure your ballast is truly that.
If you've decided that it's time to top up your bond exposure after a long period of downplaying the asset class, pick your spots carefully. High-risk fixed-income assets like emerging-markets and high-yield bonds may entice with their strong near-term returns, but such bonds often struggle more than high-quality bonds in equity-market shocks. If you're seeking true ballast for the equity piece of your portfolio, focus on boring, high-quality core fixed-income funds. The linchpin bond holding in my model ETF portfolios, for example, is  iShares Core Total USD Bond Market ETF . It includes a dash of high-yield exposure, but that stake amounts to less than 6% of total assets.

5. Recognize how much is in your hands.
Last but not least, the long-running strength of the equity market has inured many investors to the fact that their own actions will have an even bigger impact on whether they meet their financial goals than market returns. But it's true. Even though the market has contributed generously to investors' accounts over the past decade, there will invariably be fallow--or worse--periods, and they typically follow the really good ones. In times like those, investors can take comfort in all of the big decisions that are in their hands: their household capital allocations, their savings rates, and their use of tax-sheltered vehicles, among others. Being deliberate about all of those decisions is the best way to take back control, even if the market's future returns are less compelling than they've been in the past.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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