Asset allocation has been one of the most hotly-debated topics in personal finance for decades. The books and articles written about the topic have undoubtedly consumed a small forest. And yet, there is still no definitive answer to the question of what is the ideal mixture of investments,stocks, bonds, cash, real estate, precious metals, domestic/foreign, etc.., a particular individual ought to hold in his/her portfolio.
It partly depends upon oneâ€™s â€śrisk toleranceâ€ť but thatâ€™s a moving target. At different points in time someone can answer an identical set of questions aimed at gauging their risk comfort level and, depending upon whatâ€™s going on in their life, the markets and the world, end up with an entirely different results.
Remember the roaring 1990s? Just about everyone you spoke was bullish on stocks. Their risk tolerance was high. (Which, in hindsight, was exactly what led to the price bubble and subsequent market crash.) These days, stung by the Great Recession and the second-worst market decline since the 1930s, the very same people would test as â€śconservative.â€ť Their asset allocation would be completely different.
Your asset allocation should be driven by factors like your age, tax bracket, whether you need income, as well as your portfolioâ€™s need for growth, diversification, and risk reduction (via strategies that apply standard deviation and correlation, for instance). Asset allocation should be drive by financial reasons, not emotional ones.
In any event, no matter how you arrive at what you decide is an appropriate asset allocation, the next hurdle is deciding on your asset location; in which accounts: taxable, pre-tax, or tax-free should you hold your investments?
If you want, say, 15% of your overall portfolio invested in an international stock fund, should you own this in your 401(k), your Roth IRA, or the account you have at brokerage firm? The difference being, of course, the tax treatment of the different accounts.(1)
Baylor University professor Bill Reichenstein, is one of the foremost experts in this area, offers the following advice:
To keep things simple, letâ€™s just consider two broad categories of assets: stocks and bonds.(2) Reichenstein points out that stocks simply get more favorable tax treatment than bonds, and as a result, in general, bonds should go in your tax-deferred and Roth accounts and stocks should go in your taxable accounts. (Clearly, municipal bonds and municipal bond mutual funds, whose interest income is tax-free, would be an exception; these belong in your taxable account.)
Reichenstein starts with the premise that most of the return from bonds is in the form of interest, which is taxed as ordinary income (currently as high as 35%). Therefore, to the extent possible, you want to hold bonds and other income-producing assets such as real estate investment trusts in retirement or Roth accounts where the tax on gains and income is either deferred or non-existent.
Your 401(k) and IRA are also good places for stock funds that have great returns, but generate a lot of short-term capital gains which would be taxed as ordinary income.
Although dividends on individual stocks are also taxed at ordinary income tax rates, capital gains tend to make up a larger portion of their return. Here there are several key tax breaks, including the ability to control when you realize a gain. If you own individual stocks for at least a year and a day, youâ€™ll pay less in tax on your profit than if the gain is realized and then withdrawn from a pre-tax retirement account. Thatâ€™s because the long-term capital gain rate is probably lower than your ordinary income tax rate.
In addition, stock prices tend to be more volatile than bonds; they fluctuate--both up and down-- more frequently and to a greater degree. Thus, there are more opportunities to â€śinviteâ€ť the government share in your investment losses if you buy, sell, and hold stocks in taxable accounts
In addition, thanks to the step up in basis, at your death stocks held in a taxable account can be passed heirs who can immediately sell them and completely avoid capital gains tax. Capital gains can also be avoided when appreciated stocks held in a taxable account are donated to a charity; whether youâ€™re dead or alive, this comes with the added bonus of a tax deduction.
So far, this probably all makes sense. You may have even heard it before.
Thatâ€™s when Reichenstein hits you with an eye-opening twist, a new way of thinking about this:No matter what type of investment you hold in a taxable account, the government â€śsharesâ€ť your risk of owning it. If it declines in value, Uncle Sam collects less because you get to deduct this from your taxes. Of course, if you collect income or realize a gain, Uncle Sam shares in this, as well. And, as mentioned, the governmentâ€™s â€ścutâ€ť varies based upon the nature of asset and the type of income/gain/loss.
Hereâ€™s the key: without going into the math,(3) the tax rate that applies not only reduces the return you get from a particular investment, it also reduces its risk. The higher the tax rate, the greater the risk reduction. Since bonds are generally taxed at a higher rate than stocks, holding bonds in a taxable account dampens their risk even further. And yet stocks, by their very nature, are the asset class that is more volatile and therefore benefit most from risk reduction!
â€śI'm not arguing you only want to put bonds in retirement accounts,â€ť says Reichenstein. â€śFor example, what if you want [an overall portfolio allocation of] 40% in bonds and 60% on stocks?" Sounds simple, but youâ€™ve got to look at where your money is today; you canâ€™t make major changes- particularly out of tax-deferred accounts- overnight. So hereâ€™s where you might start:
$80,000 in Retirement Acct. $20,000 in Taxable Acct.
Bonds: $40,000 Stocks: $20,000
Knowing where you ideally want to end up can help you make important decisions about where to invest in the future. For instance, you might choose to direct your retirement contribution into the Roth portion of your 401(k) instead of the tax-deductible side. Or split it between the two.
Reichenstein adds that you also need to build liquidity into your taxable account in the form of cash, CDs or short-term securities in case â€śsomething happens- you need four new tires- you canâ€™t take that money out of your 403(b).â€ť Setting aside three to six monthâ€™s worth of living expenses in an emergency fund is probably one of the most difficult- and most valuable- financial exercises you can undertake.
Why not make it a 2011 priority?
1.While this, of course, is subject to change, we at least have clarity of what the taxes are likely to be for at least the next two years.
2. Those who wish to delve into the math behind this are referred to: Reichenstein, William, â€śAsset Allocation and Asset Location Decisions Revisited,â€ť Journal of Wealth Management, Summer, 2001, pages 16-26.
3. â€śMean-variance optimization,â€ť for all of you smarty-pants. (Refer to endnote #2)
Ms. Buckner is a retirement and financial planning specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content.