Is Your Asset Allocation Appropriate?

The following is an excerpt from Christine Benz’s recent webcast, Tune Up Your Portfolio in Uncertain Times. Watch the full webcast.

Christine Benz: Moving over to talk about asset allocation. This is the next key step in the process to look at your portfolio's personal asset allocation. A tool I have often enthused about for checking your portfolio's asset allocation is our X-Ray functionality on Morningstar.com. So, if you have a portfolio saved on Morningstar.com, you can click on the X-Ray tab to review your portfolio's X-ray. There's also a tool called Instant X-Ray that you can find on Morningstar.com where you can add in your portfolio's holdings and you can see your portfolio's total allocation. So, if you go through that process, you'll see a screen that looks like this one that has your asset allocation, arrayed in a pie chart, which is what you see at the top left.

The cool thing about X-Ray is that it shows you your portfolio's actual asset-class exposures. So, if you have mutual funds in your portfolio and actively managed mutual funds in your portfolio, it will drill into those portfolios and apportion your total asset-class exposure accordingly. So, if you have an international fund, for example, that holds some U.S. stocks, well, that will count toward your U.S. weighting. If you have a large-value fund that also holds some large-blend stocks or some mid-value stocks, it will show up in terms of your style box exposure. So, X-Ray is a good way to get your arms around your portfolio's actual asset-class exposures. That's the starting point for this exercise.

The next step is to compare that asset allocation to your target allocation. And at this stage, I think many investors might say, "Wait a minute, I don't have a target." And that's totally fine. I think the key is to get your arms around something reasonable in terms of evaluating your portfolio's asset-class exposures. So, a really quick and dirty way to do this would be to look at a good target-date fund geared toward someone in your age band. So, if you think you'll retire in 2040, for example, look at some of the target-date 2040 funds. We also have Morningstar Lifetime Allocation Indexes, which I often refer to. You can see aggressive, moderate, and conservative flavors of those indexes. I think those are another lens for gauging your portfolio's asset-class exposures just to see whether you're on track.

The issue with asset-class exposures and targets for them is that it's really tough to come up with one-size-fits-all asset allocations. It depends on a lot of things. So, it depends on your human capital, so your proximity to needing your money, certainly, but also just the volatility of that capital. If you're someone who is a commission-based salesperson, for example, you may have periods where you're relatively flush, but you might also have periods where your income isn't as strong. That argues for being a little bit more conservative in terms of your asset allocation. You also want to think about all of your assets, so not just your personal retirement assets, but if you and your spouse will be embarking on retirement together and drawing upon the same portfolio. Looking at all of those assets together, I think, is a good way to gauge asset allocation. But those are some rough measures that you can use to evaluate the appropriateness of your asset allocation given your situation.

As investors review their asset-allocation exposures, one thing that might jump out at you is that you may be fairly far off from whatever targets you've laid out for yourself. I think a good rule of thumb to bear in mind is that you want to rebalance your portfolio's exposures if you've drifted 5 or 10 percentage points from your target allocations. So, a portfolio that was 60% equity/40% bond five years ago would now be over 70% equity and roughly 30% bond. So, that hands-off portfolio has probably gotten more aggressive for many investors. Similarly, a portfolio that has not been rebalanced between international and U.S. would have seen its U.S. component drift higher. And then, we talked about how value stocks had a really great run in 2021. That was a relatively new phenomenon. We've seen growth stocks really outperform value by a big margin over the past five years. So, that's another part of your portfolio's exposure to take a closer look at, whether you should rebalance from growth into value because hands-off has probably made your portfolio heavier on stocks, heavier on U.S. stocks, and heavier on growth stocks if you haven't done anything to it.

If you're someone who is using the bucket system for your portfolio, and this is especially relevant for people who are retired and who are in drawdown mode, I think the Bucket approach can be a helpful way to gauge the appropriateness of your current asset-allocation mix. So, in my basic Bucket setup, I've set aside two years' worth of portfolio withdrawals in cash--so not taking any risks, not taking any chances with this portion of the portfolio. Bucket 2 is accounting for another five to eight years' worth of portfolio withdrawals. That's taking a little bit more risk with that portion of the portfolio but not too much. So, that portion of the portfolio is generally anchored in high-quality short- and intermediate-term bonds, bond funds. You might have a little bit of Treasury Inflation-Protected Securities exposure in this portfolio. You might have a dash of equities exposure. With those two buckets, you're accounting for 10 years' worth of portfolio withdrawals roughly, eight to 10 years, and that means that if Armageddon occurs in the stock market, you would be able to essentially spend through that safe portion of the portfolio without having to touch the equity assets, and that's especially important if the market continues to encounter volatility. You'd want to ensure that your plan is set up so you're not having to touch depreciated equity assets. And then, assets for years 10 and beyond of your portfolio withdrawals, I think can safely be parked in a globally diversified portfolio of equities. But this is the basic Bucket setup. I think it's helpful to use as kind of a sniff test on the viability of whatever your asset allocation looks like today.

If we wanted to translate that Bucket system into an actual model portfolio--and I have lots of different variations of these model portfolios on Morningstar.com--that would start out with Bucket 1, which would include two years' worth of portfolio withdrawals. So, assuming that we're taking $60,000 out of the portfolio per year, I'd have $120,000 in cash investments. And then, another eight years' worth of portfolio withdrawals, so $480,000 of the portfolio would be in that generally high-quality, fixed-income portfolio. And then, finally, the Bucket 3 is the long-term growth engine of the portfolio. That's generally a globally diversified equity portfolio. And here's where I would park a little bit of--if I wanted to use some of the higher-yielding fixed-income types, I'd stash them in this portion of the portfolio where I had a nice, long time horizon for them. So, I think this framework can be helpful as you think about the appropriateness of your retirement plan. Even if you're not using a Bucket strategy, I think it can be a helpful check on whatever your asset allocation is.

Dig deeper: Assess Your Asset Allocation for Retirement

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