A Quarter-End Stock Market Investment Portfolio Checkup in 5 Steps, March 29,2012.

Answer these questions to ensure your portfolio is well-positioned for what lies ahead.

“What now?” That’s what many investors are asking themselves after a stunning rally in the first quarter of 2012, in which the S&P 500 posted a double-digit gain and many higher-risk investments, especially in the technology and financial-services sectors, returned substantially more than that.As you conduct a first-quarter audit of your portfolio, the following questions should be top-of-mind.

 1) Is your asset mix on track?

With a market swing as robust as the one we’ve just experienced–with equities surging and bond gains muted–it’s a good time to check up on whether the market action has pushed your asset allocation out of line with your targets. Use our X-Ray tool to view your aggregate asset-allocation exposure. If your current equity weighting is only a few percentage points higher than your target allocation, there’s no need to take action. However, if your equity allocation has bumped 5 or 10 percentage points above your target weighting, it’s time to put rebalancing on your radar. This article discusses the ins and outs of rebalancing, including the importance of restoring balance in a tax-efficient manner. Concentrating your rebalancing efforts in tax-sheltered vehicles such as IRAs and 401(k)s, as well as using new assets to restore your asset-allocation mix, are two good ways to rebalance tax-efficiently. But would-be rebalancers should take note: Even though equities have run up during the past several years, bonds aren’t exceptionally cheap at this time, and rising rates could crimp bond prices, as Morningstar senior securities analyst Dave Sekera notes in this article. Morningstar director of economic analysis Bob Johnson also voiced trepidation about the bond market in this article. Thus, if your portfolio is dramatically light on bonds right now, the best strategy might be to slowly deploy the money over a period of months rather than shifting a large pool of assets into the bond market all in one go.

2) How vulnerable is your bond portfolio?

At the same time, it’s sensible to think about the composition of current and prospective bond holdings, and specifically, just how vulnerable your portfolio might be in the face of rising interest rates. Long-term interest rates jumped up toward the end of the first quarter, crimping the prices of some bonds long on duration, a measure of interest-rate sensitivity. The most rate-sensitive bond-fund type, long-term government bonds, lost 6% during the quarter. Morningstar director of fixed-income research Eric Jacobson shared some tips for navigating the currently tricky fixed-income environment in this video. I think it’s also worth conducting an audit of your portfolio’s interest-rate sensitivity. A quick-and-dirty method is to see how your funds fared during the month of March: The more rate-sensitive, the worse their results were apt to be. If you’d like to be somewhat more precise in gauging your portfolio’s rate sensitivity and what to expect in the future, this articlediscusses an easy-to-use rule of thumb. 

3) Are you adequately protected against inflation?

Johnson thinks that runaway inflation isn’t a likely scenario, high gas prices notwithstanding. Nonetheless, every portfolio should include a measure of inflation protection, and that will be especially important if the economy continues to pick up steam. For accumulators, stocks offer the best way to outgun inflation over time. Those nearing or in retirement, meanwhile, will want to be careful about playing it too safe with bonds and cash, given that even normal inflation rates could gobble up the meager yields that those securities are throwing off right now. Retirees and pre-retirees should also make sure that their portfolios include a targeted bulwark against inflation because cost-of-living increases could steadily chip away at the purchasing power of the dollars they draw from their portfolios. Treasury Inflation-Protected Securities provide the most explicit hedge against inflation. However, like all Treasuries, their yields are ultralow, and they’re also sensitive to interest-rate changes. (The average TIPS fund lost even more than the typical intermediate-term government bond fund during the month of March.) If you’re in or nearing retirement and your fixed-income portfolio is far shy of the 20%-30% TIPS stake discussed in this article, consider dollar-cost averaging into the asset class during a period of months. Morningstar Investment Services’ Marta Norton laid out some other ideas for inflation-protecting a portfolio–including bank-loan funds–in this video.

4) Is your equity portfolio fighting the last war?

Although stocks look more attractive to our analyst team than bonds, according to Morningstar’s Heather Brilliant, they’re a lot less attractive than they were even three months ago. With the average stock in our coverage universe trading close to our analysts’ estimate of fair value, prudent equity investors need to pick their spots and make sure their portfolios aren’t unduly exposed to overheating sectors. Defensive areas such as health care and consumer staples were cheap just a year ago but are now trading in line with or slightly above our analysts’ estimates of fair value; ditto for utilities and technology. Real estate is the most overvalued sector, based on our analysts’ estimates of fair value, perhaps exacerbated by investors’ zeal for all things income-producing. Meanwhile, economically sensitive sectors such as basic materials and energy boast the most attractive valuations currently. Does all of this mean you should up-end your portfolio and shift all assets into energy producers and gravel purveyors? No. But if you’re adding new money to individual equities–funding an IRA, perhaps–focusing on securities with Morningstar Ratings for stocks of 4 or 5 stars, which signal low valuations, is a good place to start. Fund investors, meanwhile, might reasonably skew new purchases toward funds that land in the value side of the Morningstar Style Box; their managers are presumably peeling back on overheating stocks and industries while adding to those with better upside potential.

5) How are you really doing?

Last but not least, check up on your performance. Rather than spending a lot of time focusing on what individual holdings have returned, which can lead to performance-chasing, devote the lion’s share of your performance review to how your portfolio is performing in aggregate. The starting point for this analysis is making sure you’re comparing your portfolio with an appropriate yardstick; this article discusses how to craft a blended benchmark you can use to gauge the strength of your security selection. To answer the bigger question of whether your portfolio is on track to help you reach your goals, Morningstar’s Asset Allocator tool can help provide a quick read, using the holdings you’ve saved in our Portfolio Manager.

Nature’s Healing Matrix

A Quarter-End Stock Market Investment Portfolio Checkup in 5 Steps, March 29,2012.

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