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.
Hi. I'm Mike Piper, the author of this blog. I'm 
Got any opinions for those of us who can’t max out our Roth/Traditional opportunities? When everything is sheltered, it would seem that going for the simplest, lowest cost funds would still apply but I wouldn’t really need to worry about tax implications.
Would you consider it important for people to have a taxable account as a kind of diversification against future changes to the IRA/401/403/457 laws?
Hi Don.
That’s the boat I’m in as well. Between my wife and I both being self-employed, we could contribute something like $55,000 per year to retirement accounts. Suffice to say, our cash flow doesn’t exactly make that possible. 😉
“When everything is sheltered, it would seem that going for the simplest, lowest cost funds would still apply but I wouldn’t really need to worry about tax implications.”
That’s my take on it.
“Would you consider it important for people to have a taxable account as a kind of diversification against future changes to the IRA/401/403/457 laws?”
We do not make a point of having funds in taxable accounts. I’m no political expert, but I have a hard time seeing a law that changes Roths so that they’re worse than taxable accounts ever being politically viable.
I think tax-deferred accounts have slightly more risk in that it’s politically easier to change tax rates than it is to pass broad tax law changes. Still, I wouldn’t be terribly concerned, especially if you’re making Roth contributions as well.
One important caveat: Prior to age 59.5, it’s important to make sure you at least have enough in taxable accounts or Roths to meet any unexpected expenses without having to pay taxes/penalties.
I would add that the single portfolio approach doesn’t work as well when you’re in the distribution phase – especially when you have accounts with different tax attributes.
For example, you wouldn’t want to fill up your 0% tax bracket with distributions from an account that only holds a stock fund if the stock market has taken a beating.
Otherwise I agree with using the single portfolio approach – it can be much more tax efficient during the accumulation/growth phase.
“When everything is sheltered, it would seem that going for the simplest, lowest cost funds would still apply but I wouldn’t really need to worry about tax implications.”
If its all tax sheltered but some is Roth and some is traditional, I favor the Roth for the assets with the greater growth potential. If the traditional IRA ends up smaller and the Roth larger because of that, than you’ll have smaller RMDs and less taxes in the future.
Paul, you can fill up your 0% tax bracket by converting some to Roth under 70 1/2 and then meet the liquidity distribution needs from taxable accounts. I get what your saying, but I don’t think it’s enough to abandon cross account allocation in retirement. Just my $.02.
Right, Dylan. I’m not saying completely abandon it, but it might make sense to hold a small bond allocation in those accounts for flexibility.
Also, I’ve worked for advisors who didn’t use the single portfolio approach with a particular client because the client just couldn’t “get it”. They’d see one account performing worse than the others and question why. When it was explained to them, they still couldn’t grasp it. So they just made every account have the same allocation. Not the most tax efficient process, but that doesn’t mean advisors won’t change their tune to keep a client.
Nice article. I am personally debating about the same issue. The only problem I see with this is rebalancing. If one of the accounts goes completely out of rebalance, it is not possible to transfer money from one account to another and you have to somehow replicate the AA. Other than that, it’s a very good advice.
–Amit
Amit: If you’re dealing with tax-sheltered accounts, and there are no costs to buy/sell holdings, rebalancing should be no problem. If you’re dealing with either of those though, you’re right that it complicates matters.
Nice article! This is actually something I did intuitively when I first starting out with passive investing. But, now that I look back on it, I can definitely see the benefit of being cognizant to maintain one overall asset allocation.
Mike,
What if I’m investing for two distinct purposes with two very different time horizons? That’s the situation I’m in: I’m investing for retirement (about 30-35 years away) and I’m investing for a purchase that’s about 15 years away. For simplicity’s sake I’m using Target Retirement funds for both (2045 and 2025, respectively). If I’ve understood the “it’s all one portfolio” approach correctly, then it seems that I’m “violating” the approach, but yet that my reasons for doing so are sound.
Any thoughts?
Thanks!
Chris
Hi Chris.
I think it still makes sense to consider things as one portfolio, if doing so will result in significant cost savings.
However, in your case, I’m not sure it will. Generally, the two scenarios in which there are significant cost savings are:
1) When implementing the desired allocation at the account level (rather than at the portfolio level) results in using high-cost funds, and
2) When implementing the desired allocation at the account level (rather than at the portfolio level) results in using tax-inefficient funds in a taxable account.
If the target funds in question are Vanguard’s, then #1 is not the case here, as they’re still low-cost. (Though some small savings could be had by switching to specific index funds and using Admiral shares.)
#2 may be the case, but I don’t know. Are we only talking about retirement accounts? Or are these target funds in a taxable account?
Mike,
Thanks for the reply.
The nearer-term purchase is indeed a TR fund in a taxable account… I did that because of the transition of the allocation from heavier in stock funds to more in bond funds as the time to withdraw the money approaches. I know that holding bond funds in a taxable account isn’t as efficient (although in my case we’re not talking about a ton of taxes), but I don’t know what else to do, given my plans to withdraw the money at a particular time and a desire for it to be more conservatively allocated as that time approaches. Do you know of a more tax-efficient strategy that accomplishes that?
Thanks again!
Chris
Chris,
As discussed on the follow-up to this post, the process is usually just to implement your overall allocation in the lowest-cost way possible.
So, in your case, you could determine the total allocation that you want at each step of the way. Then every year when you rebalance, implement that total allocation.
Two caveats being:
1) If a) the purchase you’re saving for in 15 years is one that doesn’t allow for penalty-free distributions from an IRA, and b) there’s a concern that, if you invest the taxable account entirely in equities, there might not be a large enough amount accessible without adverse tax consequences when that time comes, you may want to use a more conservative allocation in the taxable account.
2) If the incremental taxes aren’t significant, then there’s really no need to bother.