Let’s recap. If you’ve been following the FFWF Investing Guide so far, you now have the basic framework of your portfolio established: you’ve worked out your ideal mix of asset classes (your asset allocation), and have a list of the best index fund choices available for each of your investment accounts. By now, you’re probably itching to pull the trigger and start investing—and we will do that next—but we do need to give some consideration to how your investments will be placed inside your portfolio. This is referred to as your portfolio’s asset location, and taking a little time now to get it right can make sure that your portfolio is optimized from the outset.
Giving some consideration to how your investments will be placed inside your portfolio can make sure that your portfolio is optimized from the outset.
I should say, first, that much of the discussion here will be centered on investors with multiple investment accounts. After all, if you are investing inside just one account, there aren’t many decisions here to be made: you’ll just be investing according to your asset allocation inside that account. But for those with multiple accounts, there are some additional considerations. Let’s get into it.
Asset Location
Put simply, asset location is deciding how you will arrange the various assets inside your portfolio. As you might have noticed, the term is very close to one’s asset allocation, but please don’t confuse the two. Whereas your portfolio’s asset allocation is your overall “mix” of asset classes, your asset location is deciding where those asset classes will be actually held in your portfolio. An example will help.
Let’s say that after reading Parts 9 and 10, you’ve decided that your overall asset allocation will be:
- 64% U.S. Stocks
- 16% International Stocks
- 20% Bonds
Let’s also say that you have three investment accounts in your portfolio: a 401k, Roth IRA, and a taxable brokerage account, and that all of them have great fund choices for each asset class. How do you know what to hold where? Should you invest in all three asset classes inside each account? Should you simplify, and just hold one asset class in each account? If so, which goes where? Is there a difference between holding bonds inside a tax-sheltered account and a taxable account (spoiler alert: yes)? These are the kinds of questions we will consider here.
Whereas your portfolio’s asset allocation is your overall “mix” of asset classes, your asset location is deciding where those asset classes will actually be held in your portfolio.
It is beyond the breadth of this guide to provide specific advice for all situations for all investors, so we are going to stick to a few simple guidelines that should help with finalizing your plan. First, know that this step can be one of the most stressful, but it truly doesn’t have to be; there is no right or wrong way to implement your plan, so I challenge you to get creative. Have fun with the process.
Regardless of your individual portfolio structure, your task here is the same: arrange your current investments, as well as those that will be bought with future contributions, so that your portfolio composition matches your asset allocation. You ideally want to do this while keeping your portfolio structure as simplified as possible, and using the best index fund options you have available. The guidelines below should help you decide how to best achieve this.
Remember the Big Picture
Simplicity is one of the main benefits to index investing, and keeping your portfolio streamlined makes portfolio maintenance down the road much more manageable. It’s important to keep in mind as we go through this that your asset allocation is figured in terms of your overall portfolio—it takes a “big picture” approach. I’ve often seen investors, during this stage of portfolio planning, attempt to implement their asset allocation inside each investment account.
Simplicity is one of the main benefits to index investing, and keeping your portfolio streamlined makes portfolio maintenance down the road much more manageable.
For example, using the allocation above, our investor might put 64% U.S. stocks, 16% international stocks, and 20% bonds inside each investment account. While this is not a mistake, per se, it does add considerable complexity to your portfolio that is largely unnecessary. Instead, simplify wherever you can. Remember: what matters is that when we look at your entire portfolio, you land near your predetermined asset allocation. This will make more sense with an example.
Our Personal Portfolio
Let’s consider my wife’s and my portfolio for a moment. In what must be sheer coincidence (ha), our asset allocation is exactly the one we’ve been using above! This means that our portfolio holds 64% U.S. stocks, 16% international stocks, and 20% bonds. We also have five investment accounts: my 457, my Roth IRA, her SEP IRA, her Roth IRA, and her 401k. So how do we hold our assets inside our portfolio? Let’s consider two options: holding our asset allocation inside each account, or simplifying. To help illustrate this, check out this highfalutin graphic I created. (Bucket list: use “highfalutin” in a blog post. Check.)
Which of the two would you rather manage? Were we to hold our asset allocation inside each account (option #1), we would end up with 15 total funds, each with its own allocation inside each account; keeping track of this kind of complex arrangement would frankly be a nightmare. But by simplifying (option #2), we only hold seven funds—with most of our accounts holding only one fund. This makes portfolio tracking much easier.
As you might have noticed, my wife’s 401k holds all three asset classes. This is intentional—this account is used as our rebalance account. We will get into that next.
Rebalance Account
As your portfolio grows, you will find that your different asset classes will grow (or sometimes even drop) at different rates. As a result, over time your actual asset allocation will naturally begin to pull away from your target asset allocation. The act of adjusting your portfolio to bring your actual allocation back in line with your target allocation is called rebalancing. We will get into the specifics of how to do this in Part 14; all you need to know right now is that it is something that every investor needs to do from time to time.
The act of adjusting your portfolio to bring your actual allocation back in line with your target allocation is called rebalancing.
Given this, it is much easier to rebalance your portfolio if you have one account that contains all of your asset classes; we will call this your rebalance account. As rebalancing sometimes requires transferring funds between asset classes, being able to do this within one account simplifies the process greatly.
How do you select your rebalance account? A couple of considerations:
- Choose an account that will be funded adequately by contributions. This will ensure that you always have your different asset classes funded sufficiently to make whatever adjustments are needed.
- Also, because manual rebalancing necessarily involves buying and selling, if possible, select a tax-sheltered account (such as a 401k, 403b, 457 or IRA) to avoid potential tax implications.
Going back to our personal portfolio for a moment. When we were in this stage of portfolio planning, we decided that my wife’s 401k would be our rebalance account. With our contribution strategy, we knew it would always be adequately funded by contributions, and when we needed to rebalance, these decisions would be sheltered entirely from taxes.
Consider Future Contributions
If your portfolio is spread across multiple accounts, you will also want to give some thought to the way these will grow as future contributions are added. As you select asset classes (and specific funds) for your various accounts, keep your future contributions in the back of your mind. Keeping that “big picture” perspective of your portfolio, evaluate where your contributions will land with your current choices.
For example, will this specific arrangement mean that you have 75% of your total portfolio contributions being invested in U.S. stocks, when your allocation only calls for 64% of your total portfolio? These are the kinds of questions to ask. Strive to have the overall “mix” of your future contributions closely match that of your asset allocation. For example, if your asset allocation calls for 20% bonds, try to arrange your portfolio so that roughly 20% of your total contribution is going into a bond fund. This will help minimize the need to rebalance very often.
Grow that Roth IRA
If you will be investing in a Roth IRA, the general rule is that you will want to place your highest growth assets here. It’s often said that Roth dollars are worth more than dollars held elsewhere. Here’s why. Because you’ve already paid taxes on your contributions into a Roth IRA, qualified distributions down the road all come out tax-free. Keep in mind that this applies both to the amount you’ve contributed as well as the growth of that money over your investment window. That growth, compounded over decades, can make Roth accounts a very potent investment tool.
Every dollar held in a Roth account is worth more than a dollar held elsewhere, and this is for one reason: taxes.
Because you’ve already front-loaded the taxes in a Roth arrangement, this means that every dollar held inside a Roth account (either an IRA or employer-sponsored account with a Roth option) has an actual value of $1.00. This cannot be said for dollars held elsewhere, for one reason: taxes. Money held in pre-tax or taxable accounts will eventually be diminished somewhat due to taxes owed. This means that the value of a dollar inside these accounts is less than $1.00, commensurate with the amount that dollar is taxed.
And because Roth dollars are worth more, I think you’ll agree: you want as many of them as possible. So goes the conventional wisdom that you want to place your assets with the highest growth potential here. Now, given our three potential asset classes—U.S. stocks, international stocks, and bonds—how do they rank for growth potential? I personally base my answer—with one caveat—on the historical average annual return of these asset classes. Based on data from Portfolio Visualizer for the past 34 years (1987 – 2021), here’s how they stack up:
- U.S. Stocks: average historical return of 10.93%
- International Stocks: average historical return of 6.02%
- Bonds: average historical return of 5.77%
Now, the caveat. You’ve heard it before, and I’ll say it again: past performance is not a reliable predictor of future performance. Though U.S. stocks have outperformed the other two asset classes significantly, this may not be the case for your (or my) particular investment window. This is important to keep in mind, but despite this, I still feel the above priority is a good general one to follow for placement of assets inside a Roth.
Considerations for Taxable Accounts
If you will be investing inside a taxable brokerage account, try to avoid placing your bond fund here if possible. Why? Well, most bond funds can be very tax-inefficient; this is because they produce interest each year which is taxed at your full marginal tax rate. And because taxable accounts provide no tax benefits, these two things combined can lead to an increased tax burden. Equity index funds (U.S. or international), on the other hand, tend to be very tax-efficient, and oftentimes are a better choice for a taxable account.
Most bond funds can be very tax-inefficient; this is because they produce interest each year which is taxed at your full marginal tax rate.
If placing bonds inside a taxable account is unavoidable, consider investing in a municipal bond fund instead. These provide partial, if not complete, tax exemption. An example of this type of fund is Vanguard’s Intermediate-Term Tax-Exempt Fund (VWITX). For more information, have a look at Vanguard’s page on Tax-exempt mutual funds.
To the Starting Block!
That’s it! My advice is not to overcomplicate this particular stage of portfolio planning. Keeping to these general guidelines will ensure that your portfolio is optimized from the outset. But please don’t feel that they are hard rules; do the best you can and you will be just fine. I promise.
So, I did mention pulling the trigger on your investment plan earlier. Are you ready? Because here’s the deal: with this step, you’ve completed your initial investment plan, and have everything you need to get started. Up next, in Part 13, we are going to implement it. I hope you’re excited (I sure am)—this is where it all begins. See you there!
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