First, let’s begin with the definition of asset allocation. Asset allocation is the implementation of an investment strategy that attempts to balance risk and reward by allocating percentages of the portfolio to different types of assets that are not directly correlated. Asset allocation can be thought of as the pie chart you often see demonstrating how much of a portfolio is invested large cap stocks, small cap stocks, international stocks, bonds, commodities, real estate, etc.
We typically begin every investment plan with a risk tolerance discussion, in order to determine the proper asset allocation for our clients. Once we determine how much of a portfolio should be ‘allocated’ to stocks and/or bonds, et cetera, we can dive in to more personalized advice. I want to stress that asset allocation is a basic necessity for any investment strategy, and even the algorithms used by most robo-advisors propose an appropriate asset allocation based on a limited number of questions.
However, we’ve found that robo-advisors often lack the ability to properly locate assets within a portfolio. This is where ‘asset location’ performed by an astute financial planner/advisor becomes a key differentiator. Typically, robo-advisors assign an asset allocation to their client after a short risk tolerance assessment. The algorithm then invests using the proper allocation in each account, whether it be a Traditional IRA, Roth IRA or taxable account (like a trust or joint account).
Asset location is a tax-minimization strategy that takes advantage of different types of investments getting different tax treatments. The best location for an investor’s assets depends on a number of different factors including financial profile, prevailing tax laws, investment holding periods, and the tax and return characteristics of the underlying securities1.
Vanguard studied the added value of an advisor (up to 3%/year in total) and calculated that proper asset location can add up to 0.75% per year to an investor’s return2, depending on their situation. We like to encourage our clients to diversify their investments, but we also encourage tax diversification in order to maximize after-tax returns throughout your life. By the time our clients are retired, we like to have three buckets to withdraw from: taxable accounts (Trust), tax-deferred accounts (IRA/401k), and tax-free accounts (Roth). Clients that have all three types of accounts are most likely to benefit from asset location.
We like to place bonds, REITs, and MLPs into pre-tax IRAs and 401ks, due to the ordinary income tax rate paid by an investor on the dividends and interest received.
Taxable accounts are appropriate for investments that will generate long-term gains and losses, or qualified dividends – as these investment returns currently have favored tax treatment.
Roth IRAs are an appropriate place for “trades” or holdings that may generate short-term capital gains, and also long-term stock holdings. Generations of investment history have proven stocks to be the highest returning investment vehicle available; and as I look forward to tax-free gains on an investment, it will likely be an investment that has the potential to double every 7-10 years.
We have some clients that review their performance on an account basis, and notice that accounts perform differently over time. The appropriate asset allocation is still applied across all the household’s accounts. If one spouse has a Roth IRA and the other a Traditional IRA, the Roth IRA typically out-performs over time due to asset location. It isn’t that we favor one spouse over the other, it is simply the most tax-efficient – and in the couple’s best interest – way to invest.
Please reach out to us if you’d like to discuss how your assets are allocated OR located – we are happy to help!
- Ken Hawkins, Investopedia, February 21, 2020
- Vanguard Whitepaper, “Putting a value on your value: Quantifying advisor’s alpha”, August 16, 2019