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Introductory Guide to Asset Location

Asset location is the process of determining which investments to keep in which accounts. That is, after you’ve determined your appropriate asset allocation, how should you divvy that up between your tax-sheltered accounts and your taxable accounts?

Example: Let’s say that you decide that your appropriate asset allocation is a simple 70/30 stock/bond split. You currently have $100,000 in your 401(k), $50,000 in a Roth IRA, and another $100,000 invested in taxable accounts.

So your grand total is $250,000, and you would like $175,000 (70%) invested in stocks and $75,000 (30%) invested in bonds. A few potential asset location options would be as follows:

  • Split each account up so that it’s allocated 70/30,
  • Invest $75,000 of your taxable account in bonds and invest everything else in stocks,
  • Invest $75,000 of your 401(k) in bonds and invest everything else in stocks, or
  • Invest all $50,000 of your Roth in bonds, $25,000 of one of your other accounts in bonds, and everything else in stocks.

Option 1: Shelter those bonds!

From a tax standpoint, it typically makes sense to put all of your bonds in tax sheltered accounts. Why? Because they pay the most taxable income.

In contrast, stock income comes in the form of either dividends (which, for the moment, are taxed at a lower rate than interest income) or capital gains (which, if the holding period for the stock was greater than one year, are also taxed at a lower rate than interest income). As a result, you stand to benefit more from tax sheltering your bonds than you do from tax sheltering your stocks.

Option 2: Split everything equally.

Rick Ferri in his All About Index Funds argues that, from a psychological point of view, each account should be split up so that it has the same asset allocation as your whole portfolio.

Ferri makes the case that, if one account were to be entirely bonds and another entirely stocks, many investors would have a hard time considering them as part of a broader portfolio, rather than separately. (And, therefore, rather than deriving the psychological comforts that usually come with having a diversified portfolio, the investor would be watching whichever account is comprised entirely of stocks and panicking whenever it goes down.)

Ferri’s viewpoint makes sense to me. I certainly see a potential psychological benefit to having a mix of asset classes in each account. However, I suspect that the value of that benefit depends largely on the individual.

Which approach is best?

Anytime there’s a math vs. psychology debate, I’m reluctant to declare one option as “best.” As for my own portfolio, however, the entire bond portion is located in my Roth IRA.

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  1. I have never really given any thought to the psychological part of asset allocation….personally I do what makes sense the most mathematically or financially…but can appreciate the psychological side of it

  2. Mathematics makes sense. It’s logical. It’s definable. You can defend all decisions.

    But, worrying, being unhappy, and losing sleep are not to be ignored. It’s important to consider how stressful financial events will affect you and your psyche.

  3. I agree, the psychological aspect seems to weigh less to me, because the tax shelter benefit for bonds is so demonstrable.

    The alternative is to equalize the allocations, and lose money from taxes, just so a person can visually verify that all of their investments are being accounted for in a grand portfolio allocation setup.

    That sounds more to me like paying extra to remain intellectually lazy, rather than to derive psychological comfort.

  4. Rick Francis says

    Why not ONLY look at a reports of the entire portfolio? That way you can follow the mathematically optomal locations and not worry about the psychology problem. I believe quicken could make this kind of report fairly easily.

    -Rick Francis

  5. Mai Krakauer says

    There’s also the rebalance issue. If you only have bonds in your Roth IRA, how do you rebalance when they’re up and your stocks are down? I would think you want stocks in all 3 of your accounts, with tax-managed funds in your taxable account. Then put bonds or other tax generating vehicles (REITs) in your Roth and 401(k). Then you have more options to rebalance, which is the corner stone of an asset allocation strategy, as I understand it.

  6. Why would it be all your bonds vs. just the corporate/non muni bonds of your state?

  7. Mai:

    For the sake of clarity, let’s continue the example from above. Let’s imagine that the investor put all $50k of his Roth in bonds, and $25k of his 401k in bonds. The rest went into stocks. Then, as you stated, bonds go up and stocks go down. (For easy math, let’s say 10% up for bonds, and 10% down for stocks.)

    In that situation, at the beginning of Year 2, the investor’s accounts would be as follows:
    Roth value: $55,000 (all in bonds)
    401k value: $95,000 ($67,500 in stocks, $27,500 in bonds)
    Taxable account: $90,000 (all in stocks)
    Grand total: $240,000 ($157,500 in stocks and $82,500 in bonds)

    To rebalance back to a 70/30 allocation, he’d want to have $72,000 in bonds, and $168,000 in stocks. To achieve that, he could simply sell $10,500 of the bond funds held in his 401k, and move them into stock funds.

    MyJourney: Yes, good point. No reason to put muni bonds in a tax-sheltered account!

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