Archives for June 2011

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It’s All One Portfolio

By a wide margin, the most common emails I receive from readers are a listing of the holdings in their portfolio and a request for feedback.

Based on those emails, one of the most common portfolio-construction mistakes is the desire to hold the same asset allocation in each account (IRA, 401(k), taxable, etc.), even if doing so results in higher costs, complexity, and taxes.

How about an Example?

Sarah has decided that she wants the following asset allocation:

  • 40% U.S. stocks
  • 30% International stocks
  • 30% Bonds

She has $50,000 in a taxable account at Vanguard, $150,000 in a traditional IRA also at Vanguard, and $100,000 in her 401(k) run by Fidelity. (So her total portfolio is $300,000, and she wants $120,000 in U.S. stocks, $90,000 in bonds, and $90,000 in international stocks.)

Sarah has the following investment choices in her 401(k):

  • Fidelity Capital & Income Fund (expense ratio 0.76%)
  • Fidelity Small Cap Stock Fund (expense ratio 1.25%)
  • Fidelity Select Health Care Portfolio (expense ratio 0.88%)
  • Spartan Total Market Index Fund (expense ratio 0.10%)
  • Fidelity Strategic Income Fund (expense ratio 0.71%)
  • Fidelity Blue Chip Growth Fund (expense ratio 0.94%)
  • Fidelity International Growth Fund (expense ratio 1.90%)
  • Fidelity Total International Equity Fund (expense ratio 1.79%)

Sarah could implement her desired 40/30/30 allocation in each of her accounts, or she could implement that allocation for the portfolio as a whole.

The “Multiple Portfolios” Approach

If Sarah views each account as a separate portfolio and uses her 40/30/30 allocation in each one, her holdings might look something like this:

Taxable account:
$20,000 Vanguard Total Stock Market Index Fund
$15,000 Vanguard Total International Stock Index Fund
$15,000 Vanguard Total Bond Market Index Fund

Traditional IRA:
$60,000 Vanguard Total Stock Market Index Fund
$45,000 Vanguard Total International Stock Index Fund
$45,000 Vanguard Total Bond Market Index Fund

401(k):
$40,000 Spartan Total Market Index Fund
$30,000 Fidelity Total International Equity Fund
$30,000 Fidelity Strategic Income Fund

The “Single Portfolio” Approach

In contrast, if she looks at everything as a single portfolio, she could do something more like this:

Taxable account:
$50,000 Vanguard Total International Stock Index Fund

Traditional IRA:
$40,000 Vanguard Total International Stock Index Fund
$20,000 Vanguard Total Stock Market Index Fund
$90,000 Vanguard Total Bond Market Index Fund

401(k):
$100,000 Spartan Total Market Index Fund

Why is the Second Portfolio Better?

The second portfolio is an improvement over the first for at least a few reasons:

  • It uses only low-cost funds, whereas the first portfolio has 60% of Sarah’s 401(k) invested in high-cost funds just to meet the 40/30/30 allocation in that account,
  • It’s more tax-efficient because it places all of her least tax-efficient holdings (the bonds) in a tax-sheltered account, and
  • It has only five moving parts to monitor rather than nine.

And Sarah’s situation is relatively simple. For investors with more accounts (especially married couples) or more complex asset allocations (i.e., more than 3 distinct asset classes), the complexity resulting from using the target allocation in each account can be significantly worse.

In short, when building your portfolio, remember: It’s all one portfolio.

A caveat: Sometimes it can be helpful to perform mental accounting tricks involving separate consideration of different pieces of your portfolio (“buckets methods” of asset allocation, for instance). Just remember that these are only mental accounting, and there’s no need to use such tricks, especially if doing so would force you to take on unnecessary costs.

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