The What (Asset Allocation) & Where (Asset Location) of Investing

Asset allocation is the most important concept in investing.

Numerous studies confirm it. They show, time after time, asset allocation accounts for 90%-plus of investment returns.

In a nutshell, asset allocation is the implementation of an investment strategy that seeks to balance risk vs. reward. It’s done by adjusting the percentage of different asset classes (stocks, bonds, cash, etc.) in a portfolio according to your risk tolerance, goals and investment time horizon.

The classic “60/40 model” is a real-life example. “60/40” refers to 60% in equities and 40% in fixed income. (Cash is usually in the mix, too.) This numeric breakdown has been widely used as a catch-all for financial advisers and institutions.

More recently — and due to the last financial crisis — a more modernistic model has evolved …

“Alternatives” have joined stocks and bonds.

The new equivalent to 60/40 is something like 50/30/20 today. The new 20% is alternatives (taking 10% away from both stocks and bonds).

According to last year’s recommended asset allocation models, the top 40 institutions devoted an average of 50.7% to stocks … 28.7% to fixed income … 17.6% to alternatives … and 3% to cash. (To see where the BlackRocks, JPMorgans and Merrill Lynches of the world allocate capital, click here.)

Typically, these three or four broad asset classes (equities, fixed income, alternatives and cash) are stockpiled with these types of investments:

• Equity bucket: U.S. stocks, foreign stocks, large stocks, small stocks, etc.

• Fixed-income bucket: U.S. bonds (Treasuries, municipal bonds, corporate bonds, etc.), foreign bonds (foreign developed sovereign debt and corporate, and the same for emerging markets).

• Alternatives bucket: Commodities, hedge funds, private equity, real estate, etc.

• Cash bucket: Cash, MMFs, short-term CDs, etc. (sometimes, cash is lumped in with fixed income).

Most individual investors grasp the asset allocation concept. And they’re able to manage it on their own. (Albeit, the alternatives sleeve can be confusing.)

But many investors aren’t aware of the importance of asset location.

And by that, I mean placing or locating assets in the most tax-efficient account type.

Image Credit: Index Fund Advisors, Inc.

This often-overlooked strategy centers on tax minimization. With asset location, an investor can take advantage of the fact that different types of investments — and different types of accounts — receive different tax treatments. (Note: If you’re using a financial planner or investment adviser, they should be taking care of this for you.)

Generally, it makes sense to place less tax-efficient assets (i.e., the bulk of total return comes from coupons and dividends taxed as ordinary income) — such as bonds — in retirement accounts (IRAs or 401(k)s). And it makes sense to place more tax-efficient assets (i.e., the bulk of total return comes from capital gains taxed at a rate less than ordinary income) — such as stocks — in taxable accounts.

If you take special care of asset placement between your taxable and retirement investment accounts, it can be financially rewarding.

Michael Kitces, a distinguished financial planner and educator I’ve seen speak at numerous investment conferences, provides a powerful example:

An investor has $500,000 in a taxable account and $500,000 in an IRA. The investor intends to implement a 50/50 asset allocation model ($500,000 in bonds and $500,000 in stocks).

The following assumptions are made… Bonds generate a long-term average return of 5% and are taxed at a 25% ordinary tax rate. Stocks generate a long-term average return of 10% and are taxed at a 15% long-term capital gains tax rate. And all investments are bought and held for 30 years.

Here is how each scenario unfolds:

Bonds held in taxable account and stocks in the IRA …

Bonds grow at a 3.75% after-tax growth rate (5% gross returns less 25% taxation) … for a total future after-tax value of $500,000 x 1.0375^30 = $1,508,736.

Stocks grow at a gross return of 10% for 30 years … but are then fully taxable when withdrawn from the IRA (still assuming a 25% tax rate) … resulting in a final after-tax value of ($500,000 x 1.10^30) x (1-0.25) = $6,543,526.

Total after-tax wealth is $8,052,262.

Stocks held in taxable account and bonds in the IRA …

Bonds grow at a 5% gross return … but then are fully taxable at the time of IRA withdrawal … for a future after-tax value of ($500,000 x 1.05^30) x (1-0.25) = $1,620,728.

Stocks grow at a gross return of 10% for 30 years … and the growth is then taxable at a 15% long-term capital gains tax rate … resulting in a gross value of ($500,000 x 1.10^30) = $8,724,701 … a tax liability of ($8.724,701 — $500,000) x (0.15) = $1,233,705 … and a final after-tax value of $8,724,701 — $1,233,705 = $7,490,996.

Total after-tax wealth is $9,111,724.

The end result is a difference of over $1 million!

This extra after-tax wealth was accomplished by strategically shuffling investments between accounts with different tax consequences.

Here’s a general roadmap illustrating where to consider placing different security types:

Source: Forbes

When making your next investment purchase, don’t just think about what to buy (asset allocation) … remember to think about where to buy it (asset location).

Best,

Grant Wasylik