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Morningstar Instant X-Ray – Three Ways to Use the Output

Thursday, March 11, 2010   

After meticulously entering your portfolio holdings into Morningstar’s free Instant X-Ray Tool, you should have a clear view of your overall asset allocation, broken down by style and region.  Now what?  Let’s discuss three important questions that you can answer using the tool’s output. 

Question 1:  Is my portfolio risk-appropriate?

Your Instant X-Ray output may show a different mix of stocks, bonds, and cash than you had expected.  In order to establish a long-term investing plan, it’s vital to build a portfolio that’s consistent with your financial and emotional tolerance for risk.  Many investors make the mistake of investing too aggressively, only to discover that they’ve exceeded their risk tolerance during a market downturn.  This usually results in selling equity investments at the worst possible time (the bottom of the market) and missing out on a subsequent market rebound.  To avoid this trap, take the time to determine your ideal asset allocation before trouble arrives. 

If you need help determining an ideal allocation, you might want to try our risk questionnaires.  After asking a series of questions to determine your risk capacity and attitude, they spit out a free, risk-appropriate portfolio recommendation based on your answers.  Of course, no online survey can perfectly assess your emotional tolerance for risk, so if you’re not sure that you can handle a given level of portfolio volatility, it’s best to err on the side of conservatism.

Question 2:  Are there holes in my asset allocation?

If your Instant X-Ray output shows that a particular style or region is absent from your portfolio, you may want to consider “filling the hole.”  Amazingly, proper diversification can simultaneously reduce portfolio volatility and boost expected returns.  To see an example that illustrates the power of diversification, check out our page on Modern Portfolio Theory.

One common portfolio hole is a lack of exposure to small company stocks.  Total market funds (e.g., Total US Stock Market, Total International Stock Market) are made up of mostly large companies, so if you own a total market fund as a core holding, a small cap fund can be a great compliment.  Historically, investors have been more than adequately compensated for the risks inherent in small company investments. 

Question 3:  How are my investments doing?

If you want to grade your portfolio’s performance, or the performance of an individual fund manager, it’s important to use the right benchmark.  Now that you know exactly how your portfolio is invested, you can compare your portfolio’s performance with a mix of market indices that mirrors your style and region exposure.  This is not a simple exercise, but the results can be noteworthy.  Don’t be surprised if you find that your portfolio of actively-managed mutual funds has significantly lower long-term returns than a comparable index portfolio.  The costs of active management are extremely difficult to overcome.

Conclusion

Armed with a portfolio X-Ray, you are much better equipped to evaluate the suitability, completeness, and performance of your investment portfolio.  Informed do-it-yourself investors make good use of this valuable tool.

Posted by George | DIY Investing | Comments (0)
 

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