Beyond Stock Picking: Why Allocation and Location Are What Really Matters

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Most people think investing is all about picking the right stocks. Often, I'm asked, "What's the next big stock" or "should buy X and sell X". While correctly choosing the right investments is important, there's a lot to be said about asset allocation and asset locations affect in a portfolio and retirement plan. First what are these terms?

• Asset Allocation: The process of determining the various asset classes in your portfolio.

  • This means choosing the percentage make up of equities, bonds, real estate, and cash/cash equivalents.

  • Ex. a conservative 65 year old that just retired may have a portfolio consistent of an asset allocation of 50% equities, 30% bonds, 10% real estate, and 10% cash.
    

• Asset Location: The process of determining asset allocation among different type of accounts.
  

  • This means rather than every account type representing the same exact asset allocation, we have a different asset allocation for each account type. That being said, for the overall invested assets, we still maintain the goal of our asset allocation. This example may help simplify it:
    

    • Scenario A: 50 Year moderate risk individual plans on retiring at 70. They've determined they want an 50% equities and 50% bonds allocation. Both their Traditional and Roth IRA represents exactly 50% equities and 50% bonds.

      • Traditional IRA = 50% Equities / 50% Bonds

      • Roth IRA = 50% Equities / 50% Bonds

      • Overall Portfolio = 50% Equities / 50% Bonds
        

    • Scenario B: The same individual decides to implement an asset location strategy where they will put majority of their high growth (equities) assets into their Roth IRA. That said, they still want their entire portfolio to maintain a 50% Equities/ 50% bonds allocation. Ex:

      • Traditional IRA = 100% Bonds

      • Roth IRA = 100% Equities

      • Overall Portfolio = 50% Equities / 50% Bonds

      • The different locations of the assets if done correctly, can provide an extra .30% annually in after-tax return (Morningstar). That's the key, after-taxes. We'll cover how this works later...
        

I would like to point out the same logic of IRAs applies to your 401(k)s.

In this blog post we will cover the following:

• Asset Allocation:

  • Why it's Important

  • How do I determine my allocation?

• Asset Location:

  • Why it's important

  • How do I determine my asset location?

    • Tax advantages of each account type

    • Taxes on different types of investments

Asset Allocation: Why it's important

For a younger investor, asset allocation can tend to be pretty irrelevant. In most cases, younger investors are going to be so heavily allocated to equities due to the extended time horizon of retirement. This is because equities represent a higher risk and a higher reward. The longer the time horizon of when you will need to withdraw your investment, the longer amount of time you have to recover from a market crash before withdrawals are needed. However, as you get older, this is where you have to evaluate, "What speed do I want to drive my car (portfolio)".

If you're 100% equities, it's like driving 30mph over the speed limit - high risk, high reward. If you're more like 60% equities and 40% bonds, it's like driving the speed limit - less risk, less reward.

Have you ever driven by great grammy on the road and noticed that she drives 20 under the speed limit? I would bet that her portfolio represents the same risk. Point is that as you get older you begin to take less risks and therefor invest into more conservative assets. Below is a good example of what we call an "Asset Allocation Glide Path" which is the change in asset allocation over years:

For someone in retirement, their portfolio will likely represent significantly less equities than bonds. This is because in the event of a big crash, the slower they drive.... the less it hurts.

Asset Allocation: How Do I Determine My Allocation?

I believe asset allocation starts with first determining the time horizon of when you will need the money in your accounts. For example, for someone focusing on investing their retirement accounts, their time horizon could be 30+ years if they are in their early 20s. This would immediately place them in an asset allocation owning majority equities (high risk assets).

Other factors that help determine your asset allocation would be:

• Risk Tolerance: are you a conservative or aggressive person by nature? Can you stomach seeing a downfall in the market of 30%+ or more? Typically, as we get older, we take less risks. Reference grammy driving 20 under the speed limit.
  

• Account liquidity: If it's an account that you consistently tap into for life expenses, then you will likely be much more conservative in this account. The last thing you need is withdrawing from an account that is heavily affected by market swings.
  

• Your Goals: Some accounts serve other purposes such as funding a purchase for a new house or kids college. These accounts should have separate asset allocations outside of your overall asset allocation you determine when planning for retirement.

When determining your asset allocation for retirement, the generalized advice is to own your age in conservative assets such as bonds. This means that if you are 65, 65% of your portfolio should be invested into bonds. While I think this is a simpleton approach and asset allocation should be better determined from the factors listed above, it is still a good start if you're not sure.

Asset Location: Why it's important

For the average investor, this may be one of the top 5 techniques I see missed and could add around .30% a year in annual returns (Morningstar). And when I say it adds .30% more to your annual return, you won't directly see this increased return on your statement. Instead, this "Phantom" return happens at the tax level.

For example, when you buy a stock in your taxable brokerage account and sell it over a year later, it will be subject to capital gains rates at either 0%, 15%, or 20% depending on how high your taxable income is for that year. This rate is incredibly more favorable than if you sold the stock within one year which would put you at ordinary income tax brackets which go up to 37%.

But now what if I told you that if you bought that exact same stock in your Roth IRA you would owe $0 taxes on the gain? While it may not show up on your statement, the after-tax return is an easy forgotten metric that is important to investing.

So, this distinction of different after-tax returns is where the value of asset location arrives. If we decide to put our highest growth assets (equities) into our most tax efficient accounts, we can create an additional after-tax return out of thin air. Let's run through an example:

For this example, an individual has bought $1,000 of stock in each of the accounts types below. After 1 year the stocks grow to $10,000 in value. He then sells all of the stocks in year 2 and in year 3 he decides to withdraw $10,000 from the account.

Scenario 1 - Taxable Brokerage: Due to the individual holding the stocks for longer than 1 year, they will owe taxes on the entire gain at capital gains rates. Let's say his bracket is 15%. This means in year 2 (the year he sold the stocks), he will owe $1,350 in taxes on the gain ($9,000 * 15%). In year 3 when he pulls out the entire $10,000, he will not owe anything in taxes as he already paid the tax bill in year 2. That said, when accounting for taxes paid in year 2, his after-tax withdrawal is realistically $8,650.

Scenario 2 - Traditional IRA: Due to the tax advantages of a Traditional IRA, he does not owe taxes at the time of sale of stock (year 2), but rather when he takes the money out of his IRA and puts it into his bank account (year 3). Due to him withdrawing, he will owe taxes on the entire $10,000 dollars at his 22% ordinary income tax bracket. This means after taxes he will have $7,800 dollars.

Scenario 3 - Roth IRA: In year 2 the individual will not owe taxes at the time of sale of the stock. Additionally, and opposite of the Traditional IRA, it will also not owe taxes on the withdrawal of funds that he put in his bank account. Therefor his after-tax return now is $10,000 which is the highest out of these scenarios.

Upon easy analysis, it would make the most sense to have equities allocated to your Roth IRA before any other account. The simple tax benefit allows for an additional after-tax gain the other accounts are unable to provide.

Asset Location: How Do I Determine my Location?

We want to match the "Tax-Efficiency" of an individual investment with the type of account. For example, bonds pay you interest at ordinary income tax rates (subject up to 37% federal brackets). Due to the inefficiency of this investment, we would want to limit the taxes on this account by putting it into a tax-deferred vehicle like the Traditional IRA. Remember, you will not owe and taxes on gains or interest in the year they are realized in a Traditional IRA. Instead, you will only owe taxes when you withdraw out of the account.

For high growth assets (think equities), we would want to put them in an account that has the most favorable tax rates in the event they had a large gain over time. This would first point us to the Roth IRA which allows for $0 in taxes both on the gain and the withdrawal from the account (assuming a qualified withdrawal). The next most advantageous account would be our taxable brokerage where we are subject to the more favorable capital gains rates. The only catch here is that you have to remember you will owe taxes on this account when you realize gains and interest in the year they are realized not withdrawn from the account.

Below is a good visual of a hypothetical asset location strategy.

Summary:

Making the correct investment choices is just one variable in your retirement planning / investing journey. I would say most beginners get caught up trying to stock pick rather than thinking big picture on what's going to progress them towards their goals.

Remember, investing is about understanding what speed you want to drive and when do you need to get to your destination. Like Grammy, as you get older you will want to dial back the speed to decrease your risk of a crash.

Asset allocation is important when understanding the timeline of your investments. Ask yourself, "When will I need this money I'm investing and how much will I be taking out?". This question is going to heavily affect your asset allocation overall, as well as at an account level.

Boring investing works so don't overlook it.