This week the stock market hit a milestone, surpassing its pre-coronavirus all-time high. There is a lot of debate about whether this is justified or sustainable—and that’s certainly an important question. But the bottom line is that your portfolio probably looks very different today from the way it looked six months or a year ago. So this may be a good time to take stock of what you own and to consider whether changes may be warranted.
In a past edition of this Portfolio Makeover series, I talked about the importance of asset allocation, and that’s definitely a critical first step. Many, in fact, believe that asset allocation explains 90% or more of a portfolio’s returns. But asset allocation isn’t the only consideration. It’s also important to evaluate the individual holdings in your portfolio. But how exactly do you do that? Especially if your portfolio is what I call a “broker’s special”—with a jumble of individual stocks, bonds, funds, and ETFs—what’s the best way to make sense of it? Here’s the step-by-step process I recommend:
Step 1: X-Ray
One of the best resources on the Internet is a tool called Instant X-Ray. Provided at no charge by the investment research firm Morningstar, this is, in my view, the best place to start. Just enter the names of each of your investments, along with the dollar amount of your holdings, and the X-Ray will return a dozen pages of analysis on your portfolio. With your report in hand, these are the sections I’d review first:
- Style: Morningstar uses a nine-square grid it calls the Style Box to illustrate the breakdown of a portfolio along two critical dimensions: You’ll see how the stocks in your portfolio fall along a spectrum from large-cap to small-cap. And you’ll see how they fall along a spectrum from growth to value. Importantly—and this is where the X-Ray concept comes in—Morningstar knows what stocks are held by every mutual fund and ETF. The result: No matter how many different funds and/or stocks you own, your X-Ray will show you exactly what you own on a consolidated basis.
- Sector: This section will show you the composition of your stock portfolio (again, including the underlying holdings in mutual funds) by industry—technology, healthcare, utilities, etc. And it will show you how the breakdown in your portfolio compares to the breakdown of the S&P 500.
- Geography: Whether you should hold international stocks—and to what degree—is a separate question. But as a starting point, it’s important to know where your portfolio currently stands.
Step 2: Oddballs
As I’ve noted before, there are lots of things you can do with your money. But in my view, there are really only four worthwhile investments: stocks, bonds, real estate and cash. That’s why you’ll want to comb your portfolio for oddballs—holdings that don’t fit into one of these straightforward categories. Some oddballs I’d keep an eye out for:
- Gold and other commodities
- Funds labeled as “alternatives”
- Structured products
- Non-traded REITs
- Leveraged ETFs
- Any other investment that carries an inscrutable name
As we’ve seen this year, the stock market and even the bond market are unpredictable enough. Why make your life harder with one of these Wall Street creations?
Step 3: Concentration
A lot has been said recently about the disproportionate success of a small number of stocks—Apple, Amazon, and so forth. Do you own some of these companies’ shares? If so, that’s great—but you also want to be careful. If a modest holding in one or more of these companies has ballooned over time and now represents a large portion of your net worth, that’s important to know. Fortunately, this is another area where your Morningstar X-Ray can help. Look for the “Top 10 Holdings” section of the report.
Step 4: Costs
The investment industry takes advantage of what I like to call the Law of Small Numbers. By pricing their funds in percentage terms, rather than in dollar terms like any other business, fund companies make their fees look small and innocuous. In reality, though, many funds’ fees are unnecessarily high. Fortunately, the trend toward index fund investing has put downward pressure on fees industry-wide. That’s a good thing—but you still want to audit your portfolio carefully. X-Ray reports include expense information. You can also check fund fees on many personal finance websites.
For most funds and ETFs, this should be easy. But if you own more complex vehicles, such as an annuity or a whole life insurance policy, you’ll have to dig a little more. But I suspect it will be worth it. In my experience, the harder it is to surface a fee, the higher it ends up being.
Step 5: Tax-efficiency
In an earlier installment of Portfolio Makeover, I detailed a process for evaluating the tax-efficiency of a mutual fund or ETF. I have found this to be one of the most overlooked aspects of an investment portfolio. But with tax season recently completed, this is a perfect time of year to look into this question.
Step 6: Benchmark
A while back, a fellow investment analyst made a simple but insightful comment: “What the hell does the S&P 500 have to do with my goals?” It was a good point. The S&P 500 is, more often than not, viewed as the gold standard against which all investments are measured. But this isn’t the only way to achieve your financial goals. In fact, academics have found that it takes only 30 or 40 stocks in order to build a portfolio that is sufficiently diversified. If your portfolio is sufficiently diversified but simply looks different from well known benchmarks like the S&P or the Dow, it’s important to ask whether that really matters. This is a somewhat subjective question—and, of course, no one has a crystal ball—but it’s an important question to stop and consider before reflexively selling an investment.
Step 7: Bonds
The above steps have focused mainly on stocks. That’s because stocks, in general, carry much more risk than bonds. But don’t overlook the bonds, or bond funds, in your portfolio. X-Ray reports include a section on bonds, and you’ll definitely want to pay close attention. After all, bonds these days offer little in the way of income. Their only appeal is that they promise to return your principal in full. So audit your bond portfolio to be sure you’re comfortable that all of them will be able to fulfill that promise.
After conducting this exercise, you may identify one or more investments that don’t make the cut. But if selling those investments would leave you with a tax bill, should you still sell it, or leave well enough alone? Stay tuned—I will address that question in a follow-up article.