Asset Location vs Asset Allocation
7 min read
What is asset allocation?
Asset allocation is simply what you own. We have all seen a pie chart representing a diversified portfolio. If you’ve lived under a rock and somehow haven’t seen such a chart, take a look below …
You are looking at a mix of different asset classes that you can own within your investment portfolio. Ownership in big businesses (US large-cap stocks), smaller businesses (US small-cap stocks), international businesses, companies located in emerging markets, and lending money to companies or governments (bonds). Pretty straightforward, and honestly, this chart is super cookie-cutter as we believe no two investors should be invested precisely the same and instead have a personalized asset allocation for their portfolio designed just for them and their goals. I digress.
What is asset location?
Asset location involves the ‘where you own’ what you own. Most investors have essentially three types of accounts that can invest.
Taxable = These accounts you pay taxes on any income kicked-off in the year you receive it (i.e., dividends and interest), and when you sell the investment at a gain, you may potentially owe long or short-term capital gains taxes (more on my TLH harvesting here).
Pre-tax = IRA, 401(k), 403(b) unless you made a Roth-election; these accounts are all pre-tax. Meaning, when you put the money in, you could deduct your contributions from your income. The money inside the account grows tax-deferred (not paying taxes each year like with a taxable account), and when you take the money out, you have the pay the taxes at your ordinary-income rate at the time of distribution. Logically, this makes sense because you didn’t pay income taxes on the front-end when you originally contributed.
After-tax = Roth IRA, Roth 401(k), etc. When you contribute to this type of account, you don’t get to deduct anything from your income in the year you put in the money in. It gets to grow tax-free, and when you tax the money out, you won’t pay any taxes.
With these three account types, there are quite a few nuances regarding restrictions and limitations (how much you can contribute each year, what age you can take funds out, etc). Still, for today’s purposes, the key takeaway is this: within all three accounts, you can own the exact investments (i.e., I could buy individual stocks, bonds, ETFs, or Mutual Funds inside any account type).
How do asset classes differ?
Performance & Risk - for this blog post, let’s review the differences between large-cap stocks and small-cap stocks and hopefully keep it super simple in the process.
Asset Class Historical Performance & Benchmark Sources
A large-cap company is defined as have a market capitalization of +$10 Billion in the US. A small-cap company is defined as have a market capitalization of between $300 Million - $2 Billion in the US.
So, now that you have all these numbers bouncing around in your head – here lies a straightforward question to test how well you’ve been following along. If the next 100 years of performance were to repeat itself, would you rather own a small-cap in your Roth or your IRA? Answer: the Roth! Remember, in your Roth; we never have to pay the taxes ever again, whereas, with the IRA, we will eventually owe taxes on any amount that we take out.
Sources:
S&P 500 Index Data: Derived from Robert Shiller's book, Irrational Exuberance, and the accompanying dataset.
MSCI EAFE Data: MSCI is a company that classifies the world’s stock markets.
Aswath Damodaran NY Stern T-Bond Performance Data.
Robert Shiller compiled statistics of U.S. home price appreciation.
Edward Mcquarrie & The Center for Research in Security Prices (CRSP) database: Small-cap US Stocks
MSCI Emerging Markets Index Dataset
Asset Allocation at the portfolio level or the account level?
A case study: let’s assume we have two identical investors. Each has $1mm of investable assets distributed amongst the following accounts: $200k Taxable, $200k after-tax (Roth), and $600k pre-tax (IRA), and they invest for the next 20 years. Regarding their risk tolerance (more on risk tolerance here vs. risk capacity here), they each opt for a ‘middle-of-the-road’ portfolio where their overall target allocation is depicted on the left.
Investor #1: Let’s call him Low-cost Luke. He is exceptionally cost-conscious and can’t justify a higher fee for seemingly the same results. Luke opts for a cookie-cutter asset allocation model designed to be plug n’ play for thousands of investors. Each of his accounts is allocated as depicted above. You may notice that each account has the same asset allocation.
Using historical performance data, we can ascertain that Luke’s respective projected value in each account after 30 years of investing grows to almost $12 Million! The performance data used assumes that Luke essentially sets his portfolio and falls asleep for 30 years. He never rebalances, so there is substantial allocation drift, but that is for another blog post.
However, to put his accounts into real, spendable dollars, we can’t forget to pay Uncle Sam. He would need to pay capital gains taxes on any gains (let’s assume 20%) in his Taxable account. To take a distribution from his Roth, he would not incur any taxes. And finally, with his IRA, he has to pay ordinary income taxes (let’s assume 35% to make it easy). As such, his after-tax balance gets slashed to just over $9 Million.
Investor #2: So, I’m not naïve that this has been relatively prosaic and humdrum so far. I love this stuff, and even for me, it has been admittedly reasonably uninteresting. Hang in there; the big payoff for the time you’ve invested into this post is about to roll in. Anyways, Investor #2, let’s call her Conscientious Cathy.
As you may notice, Cathy’s performance is identical to Luke’s. Her accounts all balloon to the same number Luke’s. However, from a tax standpoint, she initially allocated the more volatile, higher expected return asset classes within more favorable accounts.
To make Luke & Cathy’s after-tax net worth apples-to-apples, we need to put her accounts into real, spendable dollars. The result: Cathy’s after-tax balance amounts to $10M - making her worth roughly $1M more than Luke.
Bottom line.
Each investor achieved the same performance with the same overall portfolio risk. But one distinct difference existed: instead of allocating her investments at the account level like Luke, Cathy instead opted to allocate her investments at the portfolio level. The distinguishing factor? She owned the more volatile, higher long-term return asset class strategically within an account where the tax liability did not increase with the value (Roth IRA). Conversely, she owned the lower-return and lower-risk chunk of her portfolio in the account, where the more you make, the more you eventually have to pay in taxes (IRA). And finally, she owned the asset classes that might not be as risky as small-cap and emerging markets but also not as safe as bonds within her taxable account. While not taken into account in this case study, this would have enabled her to benefit from more lucrative and strategic tax-loss harvesting each year.
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Both investors have the same gross annualized return of 8.61%. Yet, Cathy’s net after-tax return outpaces Luke’s by only 0.38%. The result = Cathy has $1M more at the end of our hypothetical scenario to either use in retirement or leave to her kids. Did she pick better ETFs/Mutual Funds/Stocks/Bonds than Luke? No! She owned the same stuff as he, but with much more customization and due diligence regarding taxes. The challenge is not to pick the best investment. The true challenge is to choose the right investment.
I’ve learned that there is very little difference in people, but that difference makes a big difference. A similar observation is reasonable when considering Luke & Cathy’s portfolio(s). I hope that this article serves as a reality check to overcome any investment apathy you may have to optimize your strategy. Even more true if you are 50 years old and would like to stop working by 55, as you only have about 120 more paychecks before retirement.
Stay the course,
