Your knowledge level, desire to be hands-on, tax status, and tolerance for short-term volatility can help you identify the right investments.
By Christine Benz | 01-24-18 | 05:00 AM | Email Article

Note: The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on Dec. 13, 2017.

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.

To see if your retirement plan is on track, an assessment of your savings/spending rates comes first. This article helps you assess preparedness during your accumulation years, and this one discusses the make-or-break figure for retirees, withdrawal rates. 

The next step is to find the best account types for your hard-earned retirement dollars, then gauge the reasonableness of your portfolio's stock/bond mix, taking into account your spending needs and life stage as well as your personal financial circumstances.

But how best to populate your retirement portfolio or decide which of your current holdings are a good fit? To help you knock those tasks off your list, it's crucial to think through your own situation, what you're trying to achieve, and your characteristics as an investor. As you do so, here are the key questions to ask.

Choice 1: Will you employ multiasset funds or discrete holdings for your stock and bond exposure?
This is one of the first forks in the road that confront many investors saving for retirement: Hand-select investments or opt for an all-in-one vehicle that encompasses varying asset classes, such as an allocation or target-date fund. Here are the pros and cons of each tack.

Employ discrete stock, bond, and other holdings.
Pros: The big advantage of using a building-block approach versus employing an allocation or target-date fund for your retirement portfolio is that you can exert tighter control over your asset allocation. You can customize your stock/bond mix to suit your own situation. Some investors may also value the ability to make tactical adjustments to their asset allocations based on their market outlooks--raising cash when long-term assets seem expensive, for example. And while multiasset funds will typically assemble a portfolio from the "house" brand of mutual funds, the investor who maintains discrete stock/bond holdings is free to graze across fund families--choosing Fidelity for fixed income, perhaps, while using Vanguard index funds for equity exposure. Finally, retirees who maintain discrete stock/bond holdings can also be strategic about which part of the portfolio they tap for living expenses; they can sell stocks in a lofty market, for example, while harvesting bond and cash assets in tough equity markets.

Cons: A retirement portfolio with distinct holdings will require more work to set up and maintain. Moreover, investors who are in charge of maintaining their own portfolio mixes may be more inclined to make adjustments to their programs, and those tweaks won't always be well timed. For example, in the wake of the bear market, many investors bought bond funds, whereas in hindsight it was a wise time to buy stocks. (In fact, many all-in-one funds were rebalancing into stocks during that period.)

If you go this route: Get some professional advice on asset allocation, either from a financial planner or by taking time to learn about asset allocation on your own. (Bill Bernstein's book The Intelligent Asset Allocator is a good starting point.) And be careful with tactical maneuvers, as even professional money managers have difficulty executing them on an ongoing basis. 

Opt for a multiasset fund.
Pros: Convenience. Employing multiasset funds, whether a static-allocation vehicle or a target-date fund, can help reduce the moving parts in your portfolio. Moreover, target-date funds do the heavy lifting of asset allocation for you. Not only do they set an initial, age-appropriate allocation, but they also manage it on an ongoing basis, making your portfolio more conservative as your goal date nears. Using a set-and-forget-it multiasset fund can also help ensure that you make changes that are psychologically difficult but helpful to your bottom line--for example, rebalancing.

Cons: Multiasset funds may be reliant on a subpar lineup of underlying investments, or may at least have a few weak links in their lineups. Nor are they usually appropriate for the tax-conscious: All but a handful of multiasset funds are geared toward investors in tax-sheltered accounts. And as useful as they can be for retirement savers, target-date funds are blunt instruments: They use a single factor--anticipated retirement date--to set their asset allocations. But people retiring in a given year might have wildly different situations that call for different asset allocations: The person retiring in 2020 with a $3 million portfolio almost certainly has different needs than the one retiring in that same year with $250,000. This article discusses some situations when off-the-shelf asset allocation guidance won't cut it. All-in-one funds can also be suboptimal for retirees in drawdown mode, as discussed here.

If you go this route: Be selective; the target-date series from Vanguard and BlackRock (LifePath Index) both receive Gold ratings currently. Also, be sure to monitor other accounts you hold in addition to your target-date fund, because the allocations you make there can undermine what's going on in the target-date fund.

Choice 2: Will you concern yourself with tax efficiency?
In contrast with the decision about whether to hold discrete stock and bond holdings or steer your money to a multiasset fund, determining whether to pay attention to tax efficiency for your retirement portfolio is more straightforward. If you hold assets in a taxable account, it's wise to pay attention to tax efficiency because you can improve your take-home return. But if you're holding the assets in a 401(k) or IRA, tax efficiency shouldn't concern you at all: Growing your nest egg as large as you can is the only thing you need to worry about.

If you're concerned with tax efficiency: Focus on securities that give you a level of control over when capital gains--and, to a lesser extent, dividends--are realized. On the short list of securities that fit the bill are individual equities, tax-managed funds, and broad-market equity exchange-traded funds and index funds. Try to minimize the role of investments whose income gets taxed at your ordinary income tax rate, such as bonds and REITs; municipal bonds will often to be a better fit for income seekers.

If you're investing via a tax-sheltered account like an IRA or a 401(k): You have carte blanche to invest in all the highly taxed investments you like, because the only taxes you'll pay will be when it comes time to withdraw your money. No one is keeping track of all the dividends and capital gains that you racked up during your holding period but never paid taxes on; instead, traditional IRA/401(k) investors will owe ordinary income taxes on the amounts they pull out. (And Roth investors won't owe any taxes at all on qualified distributions.) Thus, investments with high year-to-year tax costs such as high-yield bonds, REITs, and fast-turnover equity funds (to the extent that you hold them in your portfolio) are a good fit for your tax-sheltered accounts.

Choice 3: Will you aim to dampen volatility in your portfolio or will you be more aggressive? 
Another consideration when selecting holdings for your portfolio is the level of volatility you're comfortable with. The past 10 years in the equity market--and the 10 years that preceded them--have provided a great laboratory for examining your own behaviors. If you've reacted poorly to market volatility--by selling yourself out of positions when they were in a trough, for example--you may want to tweak your portfolio and its holdings to emphasize downside protection. On the flip side, if you know that you can handle higher volatility if the prospect of higher returns comes along with it, you might consider shading your portfolio toward the aggressive.

If you're aiming for a lower-volatility portfolio: The main way to bring your portfolio's volatility level down is to adjust its asset allocation, but you can also reduce your portfolio's ups and downs by focusing on investments that take a risk-conscious approach to a given asset class. When assigning  Medalist ratings, Morningstar's analysts take into account funds' attention to downside protection.

If you can tolerate more volatility: Have you been positively stoic through the market's gyrations? If so, you may want to tweak your portfolio--both its asset allocation and your investment selections--to put a greater emphasis on investments that have the potential for higher long-term rewards, even though they come with higher volatility. For example, a highly concentrated equity fund like  Oakmark Select , while not for the faint of heart, could serve as a core equity position for your retirement portfolio.

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Christine Benz has a position in the following securities mentioned above: OAKLX Find out about Morningstar's editorial policies.
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