Asset Allocation

Asset Location vs. Asset Allocation: The Winning Formula for Wealth

Have you ever wondered why your savings aren't growing even though you're contributing to an investment account? It may be because you haven't set your investment strategy.

That's what happened to Mariam.

Now, Mariam knew the importance of investing and that her bank account wouldn't cut it when it came to satisfying her long-term financial independence goals. But, like many uninitiated investors, Mariam misunderstood the concept of investing and believed that simply opening an investment account would guarantee high returns.

Sound familiar?

Well, in Mariam's case, she opened a Roth IRA, because that's what she's heard she's supposed to do. In fact, Mariam believed that her Roth IRA was all she needed, not realizing that the account itself was just a vessel for her investment strategy.

And how many of us have ever made that same mistake?

Well, everything changed when Mariam discovered that her Roth IRA wasn't performing as well as she had hoped. And it turns out that her account was all sitting in cash and not actually invested. That's when she realized that she had focused too much on the account itself and not enough on the underlying investment strategy.

So, what did she do?

Well, frustrated with her situation, Mariam took the time to track down resources and professional assistance that helped her discover that focusing solely on her Roth IRA may not have been a solid strategy from the start.

To be sure, Mariam discovered that the key to a solid investment strategy begins with putting her savings not only in suitable buckets, but also in choosing an ideal mix of stocks, bonds, and other assets that align with her near- and long-term life and savings goals.

Now, with a renewed sense of confidence, Mariam implemented her new investment strategy. And it was at that point that she knew she was making informed decisions and using all available savings vehicles, like her brokerage, employer retirement plan, and her IRA in an orderly manner.

So, what's the moral of the story here? Well, to build real wealth, it's essential to not just put money in an investment account, but also to understand the difference between asset location (that's the types of investment accounts) and asset allocation (or your investment strategy) and use them effectively within your overall financial plan.

Understand Your Investment Account Options

Indeed, understanding the difference between asset location and asset allocation is just as crucial as knowing which type of account to stash your cash in and how to make that money work for you once it's saved.

Account Asset Location

So, what is asset location? Well, this approach refers to placing your savings contributions into different savings buckets, or types of accounts based on their tax treatment. Now, these accounts might include taxable accounts, tax-deferred accounts (like a 401k and traditional IRA), and tax-free accounts (like a Roth IRA).

And, what's the whole point of asset location? Well, the point of asset location is to maximize the tax efficiency of your investment portfolio. And while you're likely aware of some of the immediate tax benefits of putting your money into these various accounts, the real focus should be on how your investments will be taxed when the money comes. That's because not being aware of your tax location could mean having less money to cover your living expenses when you need it the most.

So then, how does asset allocation differ from asset location? Well, asset allocation is the art of spreading your investments across various asset classes like stocks, bonds, cash, and other investments. The goal here is to build a balanced and diversified portfolio that vibes with your risk tolerance, time horizon, and financial goals.

Indeed, a well-diversified portfolio keeps your overall risk in check since your investments are spread across different assets, which react differently to market ups and downs. Now, before we talk about how to invest your savings, let's discuss the various savings buckets, or account types, and what they're typically used for.

Brokerage Accounts

Let's begin by taking a look at brokerage accounts. Now, a brokerage account is the most basic type of investment account that you'd open at a firm like Schwab, Fidelity, or Vanguard. And you can think of a brokerage account as your flexible platform for chasing various financial goals, like growing your wealth, saving for retirement, or funding major life expenses.

These accounts let you buy and sell various assets, like stocks, bonds, mutual funds, and ETFs, which promotes portfolio diversification and long-term growth.

Now, unlike retirement accounts such as 401ks and IRAs, brokerage accounts don't offer tax-deferral benefits. This means that you fund these accounts with after-tax dollars, and you'll likely have to pay taxes on your capital gains, dividends, and interest in the year they are earned. Now, it's possible to reduce these tax burdens through various investment strategies, but we'll save that discussion for a future report.

For now, what's essential to note here, though, is that while brokerage accounts don't have the same tax perks as other tax-advantaged accounts, they still allow you to put your savings to work for the long-term while giving you the flexibility to pull your money out penalty-free anytime you need it.

Retirement Accounts (401k, 403b, IRA)

Now, retirement accounts like 401ks, 403bs, and IRAs are tailor-made to help you save for your golden years. Now, when it comes to retirement accounts available through your employer, what’s essential to note is that in most cases these account types allow you to make contributions on a pre-tax basis, which means that you're putting more money to work before Uncle Sam gets his share of your earnings.

And in the case of Traditional IRAs, after-tax contributions can be tax deductible in certain circumstances. Either way, money in these accounts grow tax-free until you’re ready to take the money out.

Sounds good so far, right? What's the catch, you ask?

Well, the catch is that you typically can't access these accounts penalty-free until age 59 1/2, and when you do, you'll likely be taxed at ordinary income tax rates. Even so, because more money is going in on a pre-tax basis in the early years as far as your contributions are concerned, the more money you're putting to work and allowing to compound over time.

Now, one caveat to note here when it comes to retirement accounts is the Roth IRA. A Roth IRA is an account that you typically set up with a brokerage firm (or Roth 401k if your employer offers it), and is funded with after-tax dollars. While you generally can't access the funds penalty-free until age 59 1/2, the benefit of a Roth IRA is that the money grows tax free, and you typically pay no tax when you take the money out.

Education Savings Accounts (529 Plans)

Now, education savings accounts, like 529 Plans, are another kind of savings bucket designed to help families save for future education expenses. And they're useful because these accounts offer a tax-advantaged way to invest and grow funds for educational purposes.

That's because earnings in a 529 Plan grow tax-free, and withdrawals for qualified education expenses don't get hit with federal income tax. What's more, some states offer tax deductions for 529 Plan contributions, which make them a compelling savings vehicle in certain situations.

Health Savings Accounts (HSAs)

And finally, health savings accounts (or HSAs) allow you to save and pay for qualified medical expenses while offering some nice tax advantages.

In fact, HSAs offer a triple tax advantage and that's because 1) contributions are made on pre-tax basis and lower your taxable income; 2) earnings grow tax-free; and 3) withdrawals for qualified medical expenses are also tax-free. And these combined tax perks make HSAs an attractive option for healthcare expenses.

So, to sum it up, there are plenty of investment accounts designed to address specific savings goals, each with its own unique tax advantage. Brokerage accounts, for example, serve as a flexible platform for pursuing various financial goals, while retirement accounts, like IRAs and 401(k)s, are all about helping you save for your retirement, offering tax-deferred growth and, in some cases, tax-deductible contributions.

Asset Location in Action

And so, why is it important to understand the difference between taxable and tax-advantaged accounts?

Well, in the book, "The Bogleheads' Guide to Investing," the authors highlight the importance of asset location in maximizing after-tax investment returns. They point out that different investments are subject to different tax treatments, and placing them in the right types of accounts can significantly impact your overall tax bill.

The authors suggest prioritizing tax-advantaged accounts, like 401(k)s and IRAs, for tax-inefficient investments, such as actively managed mutual funds and real estate investment trusts (REITs). These investments generate more taxable income, so holding them in tax-advantaged accounts can potentially shrink your overall tax bill.

On the flip side, tax-efficient investments, like broad-based index funds and municipal bonds, might be best held in taxable accounts. These investments generate less taxable income, so holding them in taxable accounts can potentially reduce your overall tax liability.

Taken together, understanding these investment accounts and their respective tax benefits can empower you to make informed decisions that align with your unique financial goals and help optimize your savings strategies.

Understand How Asset Allocation Puts Your Money to Work

Okay, so now that you understand where your savings should go and why, let's discuss how you can actually put your money to work through asset allocation.

And, what is asset allocation?

Well, as we mentioned earlier, asset allocation refers to the process of dividing your savings among different asset classes in order to balance risk and return. Again, these assets include stocks and bonds, and US and international investments. And we take this approach because what we're trying to do is not only grow your savings, but reduce the chance for losses by diversifying risk across various assets.

The Power of Asset Allocation

So how much does asset allocation matter? Well, years ago a group of financial researchers led by Gary Brinson, Ralph Hood, and Gilbert Bebower wanted to figure out which factors influenced the returns investors earned from their portfolios.

So, to do this, they looked at the performance of a big group of pension funds. And what they found was that there are generally three main factors that determine the returns earned by the funds themselves, including security selection, market timing, and asset allocation.

Now, when it comes to security selection, this process refers to the act of choosing individual investments held in a portfolio, like which stocks or bonds to buy. And what the researchers wanted to understand was whether fund performance was driven by terrific stock picking, or some other factor.

And, so what did they find? Well, what the researchers found in their study was that stock picking was actually the least important factor in determining a portfolio's long-term returns.

In fact, the researchers found that the asset allocation decision was the most critical factor in determining a portfolio's returns. Indeed, the paper shows that even trying to time the market was less important than getting the asset allocation right.

And why's that?

Well, that's because different types of investments have different levels of risk and return. For example, stocks are generally riskier than bonds, but also have the potential for higher returns. Cash, on the other hand, is less risky but also has lower returns.

And the fact is that, over the long-term, markets typically don't move up, or down, in a straight line. Therefore, by choosing a mix of investments that matches your goals and risk tolerance, you can maximize your chances of earning solid returns over the long run. Indeed, trying to time the market or pick individual investments is less important in the grand scheme of things than holding a diversified basket of investments.

The Benefits of Diversification and Risk Management

So, what makes asset allocation the most important decision when it comes to long-term investors? Well, when it comes down to it, as the old adage goes, it doesn't matter how much you make but how much you keep.

Indeed, Benjamin Graham, once a professor at Columbia Business School and regarded as the father of value investing, says that "the essence of portfolio management is the management of risks, not the management of returns."

Indeed, if we were to boil down the purpose of asset allocation to its essence, it could be encompassed in that single quote from Graham. Now, I know what you're likely going to say at this point and that's, "doesn't a diversified portfolio produce returns that are less than those of a single stock, or highly concentrated investment position?"

And, well, the answer here is, "it depends…"

The fact is that asset allocation is not so much about optimizing returns as it is about managing risk so you can stay in the investing game when markets inevitably fall, allowing you to achieve your long-term savings goals.

What do we mean here? Well, let me give you an example from the perspective of workers who concentrated their retirement savings in employer stock.

Now, in 2008, Wachovia, one of the largest financial institutions here in the US, suffered significant losses due to its exposure to toxic mortgage assets which ultimately led to its failure. Now, at its peak, the company had over 3,400 retail banking branches and employed more than 120,000 people.

Even so, a few bad business decisions combined with a perfect storm that was the Global Financial Crisis, led to a steep decline in the value of Wachovia's stock, ultimately wiping out the retirement savings of many of its workers.

More recently, many tech investors who had jumped on board the tech stock rally that took place between 2020-2021 ultimately saw their savings diminished after inflation, war tensions and aggressive rate hikes led to a notable tech stock selloff in 2022. Indeed, remember all of the unicorn IPOs and SPACs that were supposed to make many millionaires? Well, there are likely many unfortunate souls out there who decided against diversification in exchange for diamond hands, and are now paying the price of holding onto their concentrated positions.

Make no mistake, diversification and risk management are essential elements of successful investing. That's because diversification helps investors spread their risk across different types of investments, while risk management helps minimize losses and maximize returns. And, by understanding the benefits of diversification and risk management, you can build an investment portfolio that is well-positioned to weather market volatility and help you achieve you long-term financial goals.

Risk Management's Role in Asset Allocation

Alright, now that we've covered the basics, let's talk about how asset allocation and asset location work together to put your money to work in a tax-efficient manner.

To this end, you'll recall that asset allocation is all about putting together your investment dream team. It's like picking players from all the different asset classes like stocks, bonds, and other risk assets. Then, by spreading your money across these various options, you're tapping into their unique strengths and making sure market ups and downs don't mess with your overall life and savings goals.

Sounds like a winning strategy, right?

Well, before you can put this money to work, you'll need to determine where your investments will hang out. More specifically, you'll need to determine how much of your investments are held in taxable accounts, tax-deferred retirement accounts, or tax-exempt places like Roth IRAs. Remember, each account type has its own set of tax advantages and distribution setbacks.

The trick here is to be savvy about which investments go where, so you get the biggest bang for your tax buck. That means putting tax-inefficient investments in tax-advantaged accounts and tax-efficient investments in taxable accounts. This way, you keep more of your hard-earned money and preserve it for the long-term.

For example, you can stash tax-inefficient investments, like high-yield bonds, in tax-deferred accounts, and tax-efficient investments, like index funds or municipal bonds, in taxable accounts.

How to Put Asset Allocation and Location to Work for You

So then, now that you know why asset location and asset allocation are essential investing decisions, the next big question that you likely have is, "where do I start?"

Saving in the Right Buckets

Well, the first decision in any disciplined investment strategy is to identify what you're saving for, and how much you need to have saved. Now, you'll likely recall that this is a topic that we've covered at length in previous reports, so we won't go into it here today. Even so, be sure to check out our previous posts if you need help on figuring out how to calculate your savings need.

Alright, so once you figure out how much you need to have saved, then the next thing we need to do is to determine which accounts need to be funded to meet your savings goals.

As you'll recall, you have three investment buckets to which you can contribute your savings, and these are taxable, tax-exempt and tax-free accounts. The key difference between these account types is the tax treatment of the investments held in each account and how gains are taxed when they occur.

Remember, in taxable accounts, for example, you could be subject to taxes on any income or capital gains generated by the investments, which can reduce your overall investment return. In tax-exempt and tax-free accounts, however, you're likely not subject to taxes on the income or gains generated by the investments, which can result in higher overall returns if you have a long enough savings horizon.

Now, to this point, when making asset location decisions, Larry Swedroe, in his book, "The Only Guide You'll Ever Need for the Right Financial Plan", recommends that you prioritize first making contributions to your tax-advantaged accounts, such as your 401(k)s, IRAs, and HSAs. That's because these accounts provide tax benefits, such as tax-deductible contributions, tax-free growth, and employer-matching contributions. Therefore, it makes sense to take advantage of these benefits as much as possible whenever you can.

Swedroe also suggests that you should consider holding tax-inefficient assets, like bonds or REITs, in your tax-advantaged accounts. By doing so, you can allow these investments to grow tax-free and reduce your tax burden on the income generated by them.

On the other hand, it may be better to hold tax-efficient assets, like stocks or ETFs, in your taxable accounts. Again, these types of investments generate less taxable income and therefore have a lower tax impact on your overall investment returns.

What's more, Swedroe believes that prioritizing tax efficiency in your asset location decisions is essential because taxes can significantly eat away at your investment returns over time. And by following a disciplined asset location strategy, you can maximize your after-tax returns and achieve your financial goals more efficiently.

Identify Your Risk Tolerance

Alright, so now that you've identified the ideal buckets to contribute money into, you're ready to invest, right?

Not so fast.

Before your money goes into your taxable, tax-exempt or tax-free account, the next decision in any disciplined investment strategy is to identify your risk tolerance.

And what is risk tolerance, you ask?

Simply put, risk tolerance reflects the amount of money you're willing to put at risk over a period of time for a given amount of gain. As the saying goes, the higher the risk, the higher the reward.

Now, in his book, "The Little Book of Common Sense Investing", Vanguard founder Jack Bogle talks about how you can identify your own investment risk tolerance by evaluating your time horizon, financial goals, comfort with volatility, and prior investment experience.

For example, when it comes to your time horizon, the longer you're willing to hold onto your investments before selling, the higher your risk tolerance. On a similar note, if you made it through the recent market selloffs without batting an eye and can handle taking short-term losses with the hope for longer-term gains, then that may be a sign that you're more risk-tolerant.

On the other hand, if your investment goal is to save for the down payment on a house, or retire in less than five years, then you may likely have a lower tolerance for risk than someone who otherwise has life goals that are years down the road. And if you're still not sure about your risk tolerance, you can complete a questionnaire to help provide you with a better gauge of where you stand.

And what is a risk tolerance questionnaire?

Well, a risk tolerance questionnaire typically consists of a series of questions about your financial situation, investment goals, time horizon, and comfort level with various investment risks. And based on your responses, the questionnaire generates a risk profile that suggests an appropriate asset allocation strategy for your investment portfolio.

Either way, Bogle believed that you should be honest with yourself about your risk tolerance, as it can be a crucial factor in determining your investment strategy. And by understanding your own risk tolerance, you can make more informed decisions about asset allocation and portfolio diversification.

Find Your Ideal Asset Allocation Framework

Now, once you have a better understanding of your risk tolerance, it's time to identify your ideal asset allocation framework. Now, you'll recall that asset allocation refers to the ideal mix of stocks and bonds held in a portfolio that reflects, in addition to your risk tolerance, your overall investment goals, income needs, and savings time horizon.

Now, generally speaking, securities like bonds have lower risk than stocks do. Therefore, if you have a low-risk tolerance, you'll likely have an investment portfolio with more bonds than stocks. Alternatively, if you have a higher risk tolerance or a longer savings horizon, you'll likely have a higher allocation to riskier assets like stocks in your portfolio.

So, how do we put these pieces together? Well, let me illustrate these two points about varying asset allocations by sharing Warren and Rebecca's story.

Now, Warren was a seasoned investor, who had spent decades building his wealth. Now on the verge of retirement, his focus was on preserving his capital and generating a steady income to support his golden years. He spent his days evaluating his portfolio, seeking out stable income-generating assets, and reminiscing about the financial lessons he had learned over the years.

Rebecca, on the other hand, still had years to go in her investment journey. To be sure, with many years ahead of her until retirement, she was keen to grow her wealth and embrace the power of compounding. That's why Rebecca spent her nights researching high-growth opportunities and learning from experienced investors like Warren.

Now, one day, Warren and Rebecca decided to learn from each other's investment strategies by sharing their insights and experiences.

That's when Warren, with his retirement just around the corner, explained to Rebecca how he crafted his own conservative asset allocation strategy. He emphasized that his strategy centered on the importance of low-risk assets such as government bonds, blue-chip stocks, and dividend-paying stocks. That's because he wanted to ensure that his investments were safe from market volatility and so his portfolio could provide a steady income stream.

Rebecca, on the other hand, shared her perspective on taking advantage of her long investment horizon. She explained to Warren that her strategy involved a more aggressive asset allocation, focusing on high-growth opportunities. She allocated a significant portion of her portfolio to emerging markets, small-cap stocks, and disruptive technology start-ups. And, she believed that the potential for outsized returns outweighed the risks, because she had plenty of time to recover from any short-term losses.

Now, as months passed, the two friends watched the markets move in different directions. Warren's portfolio, with its emphasis on stable investments, slowly but steadily gained in value. He knew that his primary goal was capital preservation and income generation, rather than chasing high returns.

Rebecca's portfolio, however, experienced substantial fluctuations, soaring to new heights one day, only to plummet the next. And throughout the year, they continued to share their experiences and insights, learning from each other's successes and failures. And by the end of the year, they discovered that both of their portfolios had performed quite well overall.

Indeed, Warren's cautious approach had provided the stability and income he needed for his impending retirement, while Rebecca's bold strategy had produced some impressive gains, setting her up for long-term wealth accumulation.

Overall, they each realized that their different investment horizons had led them to different asset allocations, and ultimately, different paths to success. Warren’s conservative approach was well-suited to his impending retirement, while Rebecca's growth-oriented strategy was ideal for her long investment horizon.

Don’t Forget About Your Investment Strategy

Warren and Rebecca’s story illustrates how different investment horizons and risk tolerances can lead to distinct asset allocation strategies, each tailored to an investor's unique circumstances and objectives. But more importantly, the big takeaway here is that by understanding the differences between various account types and their tax implications, you can avoid a common mistake of confusing account contributions with an investment strategy.

And this knowledge is essential because it can help you create personalized, effective financial plans that align with your unique goals and circumstances. And, when you understand the distinction between accounts and strategies, you can better allocate your financial resources, choose appropriate investments, and monitor their progress toward your financial goals. More importantly, having this understanding and actually doing the work can put you one step closer to becoming the master of your own financial independence journey.

---

by Peter Donisanu