Asset LOCATION Is Key To Building Wealth, Part 1

As people learn to manage and invest their money it doesn’t take long before they hear about “Asset Allocation”. Your asset allocation is the distribution of your investments across multiple asset classes. The theory goes that by spreading your assets across multiple asset classes you can maintain or even improve your returns while reducing your overall risk (i.e. portfolio volatility). This is possible because different types of investments go up and down at different times, and therefore together can reduce volitality.

Asset allocation is very important, and some studies have shown that it is the most important factor when it comes to generating investment returns. I would argue that your savings amount is more important, but beyond that asset allocation is key.

Here’s the problem. People spend time figuring out their asset allocation, but they typically make the mistake with regards to their Asset LOCATION.

Asset Location refers to where you locate your investments and depends on the type of accounts you have available. A simple example would typically include a tax-deffered account (like a 401k, 403b, or traditional IRA) and a taxable account. With the popularity of the Roth IRA, a slightly more complicated scenario might include a traditional IRA, a Roth IRA, and taxable accounts.

I’ve been researching asset location recommendations for a while now and would like to share what I’ve discovered. Please keep in mind that I am not a financial advisor, so please do your own research and make your own decisions regarding this discussion.

Asset Location Basics

Once you’ve determined your asset allocation the next step is to decide where to locate these investments. The main idea behind asset allocation is to create a tax-efficient portfolio. The standard advice is to use tax-deffered accounts for the most tax-INEFFICIENT investments, and to keep the tax-EFFICIENT investments in a taxable account. This advise is reasonable sound, and if followed would most likely be better than what most people typically do (myself included).

Asset location is a KEY decision that should be thought through at the very beginning of your investing lifetime. I’ve made a lot of mistakes in this area, and have paid quite a price to reorganize my portfolio the way it should be.

Although some mutual funds try to monitor and maintain some level of tax efficiency, most do not. You can evaluate the tax efficieny of mutual funds by using Morningstar.com. In general, however, the following asset classes are listed from most tax efficient to least tax efficient:

• Tax-exempt (municiple) bonds
• Broad-market stock index funds
• Tax-managed stock
• Large growth stocks
• International stocks
• Large value stocks
• Small cap stocks
• Small cap value stocks
• Balanced funds
• REITs
• TIPS
• Taxable bonds
• High-yield bonds

This list is not absolute but it is directionally correct. Based on this information you would prefer to hold REITs and taxable bonds in a tax-deffered account and hold equity investments with low turnover (index funds) in a taxable account.

My Money Blog has a good visual diagram of this ranking (although it is reversed from the way I listed it).

There appear to be two key academic research papers that address the issue of asset location:

• http://cowles.econ.yale.edu/conferences/brainard/shoven.pdf
• http://wpweb2.tepper.cmu.edu/spatt/location.pdf

The first paper is written by Shoven and Porterba, and includes an analysis of several different scenarios. The study includes a look at including municiple bonds in taxable accounts instead of using taxable bonds in tax-deffered accounts, and therefore helps answer one of my questions above. The key take-aways from this study, in my opinion, include:

• If an investor uses actively managed funds it is best to place those funds in the tax-sheltered account. This is due to the fact that most actively managed funds are tax-inefficient.
• If an investor uses passively-managed index funds they would do better to hold taxable bonds in a tax-deferred account. Equities would only be included in the tax-deferred account if there was still room after purchases all of the desired taxable bonds in order to achieve the desired asset allocation.
• Municipal bonds are preferred to taxable bonds for medium and high tax individuals if held in a taxable account.

Therefore, for passive investors (like me) it is best for me to purchase taxable bonds in my tax-deferred accounts until I reach my desired asset allocation. I can then proceed to fill out the rest of my retirement accounts with equity investments.

I understand the reasoning behind after-tax returns, but this recommendation still feels a little counter-intuitive to me. I always tend to think I want most of my retirement assets to be in my tax-deferred accounts. If I follow this advice, however, this may not be the case. I plan to save for retirement in both taxable and tax-deferred accounts (for flexibility). If I am able to save money in after-tax accounts it is likely that my retirement accounts will grow more slowly than my retirement accounts (bonds vs. stocks). Therefore most of my retirement savings will actually be in after-tax investments. This could be a good thing, but it’s something I’ll have to think about a bit further.

Image Credit: cogdogblog

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