Morningstar’s investment pyramid can help investors assess their financial priorities. Like the original food pyramid, the items towards the base of the financial pyramid are the most important--the equivalent of whole grains, fruits and vegetables.
Meanwhile, the top of the pyramid features items that have less of an impact on the success or failure of their financial plans. Think of them as the investing equivalent of sugars and fats: they keep life interesting, but they're not essential to keep us running in peak form and can even work against us in outsized quantities.
As you periodically check up on your portfolio, the pyramid can be a useful source to determine where to focus your energy. Give relatively more time and attention to those items that will really make or break your plan, while spending less time on those items that won't have much of an impact.
Here's a portfolio-review checklist informed by our pyramid.
Check-up Item 1: Have your goals changed?
The base of the financial pyramid is "having a goal," or more specifically, identifying and quantifying what you want to achieve with your money. Thus, the first step of any sort of financial-review process should be to reassess your goals. Has anything changed in terms of what you'd like to achieve, how much it will cost, when you'll need the money, and for how long?
For example, have you decided you'd like to retire five years earlier than you had originally expected, thus necessitating that you come up with a larger nest egg well ahead of your previous plan? Or perhaps your child has decided to go into an apprentice scheme rather than go to university, so your total outlay for higher education will be lower than you anticipated. Any substantive changes in your goals—the amount, asset allocation, your distance to them, and their duration--should prompt a re-evaluation of your whole plan.
If you haven't done so already, group your goals into one of three bands: short-term goals (goals you'd like to achieve in five or fewer years), intermediate-term goals (five to 15 years from now), and long-term goals (15 years or more in the future). Once you've done that, prioritise your goals within each time frame. Be sure to include debt retirement on your list of goals.
The next step is to estimate exactly how much those goals will cost you. If your goal is close at hand--such as buying a car next summer--quantifying it is straightforward. But if it's a goal that's further in the future or one that you'll pay for during several years, the calculation may be more complicated; you'll also have to factor in inflation as well as assume a reasonable rate of return from your investments.
Check-up Item 2: Is your savings or spending programme on track?
The next band of the pyramid is "managing your saving and spending rate." Thus, if you're in accumulation mode, a key focus of your portfolio review should be to determine whether your current savings rate puts you on track to hit your financial goals. Or do you need to kick up your savings to improve your probability of success?
If you're already retired and in withdrawal mode, a key thrust of your portfolio review should be to take stock of your spending rate. Does it fall within the guidelines you've laid out for yourself?
Check-up Item 3: How does your asset allocation compare with your targets?
Asset allocation is the next band of our pyramid, and checking up on your stock/bond/cash mix should be high on your priority list, too. After all, how you've apportioned your assets is one of the most, if not the most, important determinants of how your portfolio performs. Morningstar's X-Ray tool is the best way to get your arms around your total portfolio's positioning, taking into account the composition of each of your underlying holdings. (If your UK-equity fund holds cash or foreign stocks, for example, X-Ray will pick up on it.)
Compare your portfolio's X-Ray allocation with those of your targets. If you don't have any targets, a good target-date fund’s asset allocation can help provide some guidance. Because those allocations are geared towards the average person with your retirement date, be sure to take into account your own personal circumstances when setting your own asset-allocation parameters. For example, if you have a pension that will supply a big portion of your in-retirement income needs, you could reasonably run with a much higher equity allocation than would be standard for someone without a pension in your age band.
Check-up Item 4: Does your portfolio align with your risk tolerance? Are you reducing exposure to the market's hot spots?
Classical economic theory holds that people are purely rational actors when it comes to making financial decisions. Because stocks generally return more than other asset classes over time, for example, investors should be comfortable sitting tight with equity-heavy portfolios despite their inevitable bumps along the way. Students of investor behaviour know that asset allocation in real life doesn't always work that way, however. Some investors get spooked and abandon stocks in periods of market volatility, while lofty markets often lead investors to enlarge their stock allocations. Morningstar's Investor Return data illustrate how these behavioural errors eat away at investors' take-home returns, sometimes exacting higher tolls than even their funds' expense ratios. That's why "Managing your own behaviour" is the next band in the pyramid.
To make sure your portfolio is in sync with your own ability to tolerate fluctuations, the next phase of the review process homes in on the risks associated with your portfolio. In addition to making sure your asset allocation looks reasonable given your life stage, check your portfolio's style, sector and geographic exposures alongside relevant benchmarks to make sure you're not making any big, unintended bets. X-Ray shows you your sector positioning relative to that of your chosen benchmark.
Check-up Item 5: Have you maxed out your tax-sheltered accounts? If any changes are warranted, can you make them in a tax-sensitive way?
"Being tax-efficient is the second-to-last item in our pyramid, and it's valuable to stitch tax matters into your check-up process, too. If you're in a position to contribute the maximum allowable amount to your ISA, for example, assess whether your current contribution rate puts you on track to hit the limit by year-end.
And if running through the preceding steps indicates that portfolio changes are in order, ensure that you're making them in a tax-sensitive way. Concentrate any selling in your tax-sheltered accounts because trading there won't trigger capital gains taxes.
Check-up Item 6: Are your holdings on track?
"Investment selection" is at the top of the pyramid. That doesn't mean you should ignore it, but it shouldn't be your preoccupation, either. As you conduct your portfolio check-up, don't focus disproportionately on individual holdings' absolute returns and return rankings, though they can be difficult to ignore. Instead, concentrate on fundamentals, revisiting whether your reason for holding each position remains intact.