What is Asset Allocation and Asset Location

Many people mistakenly believe that their individual investment selections have the biggest impact on the success of their portfolio. However, this isn’t necessarily the case. Time generally has the biggest impact on the success of your investment portfolio.

Aside from time, asset allocation is one of the biggest determinants of a successful portfolio performance. However, Asset location is one of the biggest determinants of how much of the profits you get to keep.

When you combine a strategic asset allocation with a strategic asset location plan, you can optimize your chances for success. I know this sounds like a bunch of financial planner jargon, so I’ll try to break it down for you in plain English.

What is Asset Allocation?

Think of asset allocation as your investment recipe. The stocks, bonds, real estate, cash, and other asset classes are the ingredients that make up the final product of your portfolio. Just as everyone’s tastes in food are different, their goals, timeline, and risk tolerance are also different, so it’s important to adjust the recipe for your own preferences.

Just as most recipes have multiple ingredients, it’s very likely that your investment portfolio should have multiple asset classes. This is an important risk management technique that should not get overlooked. 

Each asset class, generally speaking, reacts differently to different news items and economic events. By having a strategic asset allocation, you can spread your risk around, so when one asset class falls, another (ideally) rises, helping to mitigate your losses and providing a smoother ride for your portfolio returns.

In general, the idea of asset allocation is to minimize your risk exposure while achieving your required level of return to accomplish your objectives. Another important aspect of determining your required return is determining how much of this money you’ll get to keep. That’s where asset location comes into play.

What is Asset Location?

Many individual investors at least have a general understanding of asset allocation or diversifying among different asset classes. However, one area that is often overlooked is the asset location, or the type of account that holds your investments.

There are more options than this, but the three main type of accounts are:

• Taxable – income is taxed in the current year (think brokerage and bank accounts, money market accounts, etc.)
• Pre-Tax/Tax Deferred – funds are invested prior to paying income tax, and no tax is due until funds are withdrawn, the amount withdrawn is fully taxable in the year of withdrawal. Think of traditional IRAs, 401(k)s, 403(b)s, etc.
• Roth – funds are taxed prior to being invested and remain tax-deferred until withdrawn. Withdrawals can be tax free if the rules are followed. This can be Roth IRAs, Roth 401(k)s, etc.

The primary reasons for asset location are for tax efficiency and some limited liability protection (laws vary by state). There are different tax rules for each account type, which is why asset location is such an important aspect of tax planning. 

How Do I Optimize These?

To fully optimize your asset allocation and asset location strategies, it’s important to consider your entire investment portfolio – a consolidation of all your investment accounts. Looking at each account individually can lead to an improper asset allocation strategy, or unfavorable tax consequences. 

When looking at your consolidated portfolio, the asset allocation (or ingredients) should be your first consideration. Taxes are important, but they shouldn’t drive all of your investment decisions. Remember, aside from time, asset allocation is one of the biggest drivers of your future success.

Once you determine the optimal asset allocation for your situation, you can determine where to put those assets with your asset location strategy. Just as each account type has different tax properties, there are different rules for each asset class. An optimal strategy will align the tax properties of the asset classes and account types to be as tax efficient as possible.

There are a variety of ways to accomplish this, but here are some general rules of thumb:

• Taxable Accounts – should hold growth stocks or other capital assets that don’t provide income. Capital gains are treated more favorably for taxes, and it allows for tax-loss harvesting. If income is needed, seek investments that provide qualified dividends, as these also receive preferential tax treatment. Municipal bonds may also be a great option, as the income is not federally taxable.
• Pre-Tax/Tax Deferred Accounts – These will be taxed at ordinary income rates when withdrawn, so it’s generally recommended to hold your income producing assets here. Think of bonds and stocks that provide non-qualified dividends. 
• Roth Accounts – when used correctly, these won’t be taxed again. This is a great place for dividend-paying stocks and index funds. You want these accounts to be aggressive to maximize the tax benefit, but you also want to be sure that you take an ideal level of risk for your situation, as there’s no tax-loss harvesting if your assets depreciate in value.

Final Thoughts

Remember, these are general rules, and your current and expected future situation should be considered to determine the asset allocation and asset location strategy that’s right for you. We generally recommend being aggressive with tax-deferred accounts (both Roth and pre-tax), as there are strategies we can use to minimize your tax liability in future years. 

The most important thing is that you start investing, or continue to invest, and that you have at least a basic strategy in place. Stick to your strategy and make adjustments as needed, and success should follow. If you’re unsure about your strategy, we’ll be happy to take a look at it for you.