Rules for Asset Allocation Implementation

By Dr. Jim Dahle, WCI Founder

Here's a question I've received in the past.

“I'm not sure I'm putting the right asset classes into the right accounts. How should that be done?”

My answer: there are a few principles to doing asset allocation correctly, but there are two prerequisites you need to do first.

 

The Prerequisites 

 

#1 Develop a Specific Asset Allocation Plan

The first step is to develop an exact asset allocation. I don't mean something vague like “60% stocks and 40% bonds.” I want you to be very specific. Every dollar in your portfolio should have a name and purpose. You should define your asset allocation very specifically, like in this example:

25% US Stocks (Total Stock Market) 10% Developed Market Stocks 5% Emerging Market Stocks 10% US Small Value Stocks 10% REITs 20% US Nominal Bonds 10% Foreign Bonds 10% TIPS

This is a reasonably complex 60/40 portfolio containing eight separate asset classes. It is likely to meet an investor's goals if it's held for the long term and combined with an adequate savings rate and reasonable goals. Like any portfolio, it isn't perfect. Without the ability to predict the future, there is no perfect portfolio. But it's good enough. Deciding on a reasonable asset allocation is the first prerequisite to this process.

 

#2 Figure Out What You Have in Each Account

The second prerequisite is understanding exactly what you have, what is available in each of your accounts, and what future contributions will look like. The best way to do this is to list it all on paper. For example, this investor may have accounts that look like this:

Total balance of all accounts: $250,000
Total contributions per year: $100,000

Account: His 401(k)
Current balance: $0
Expected contributions: $51,000 per year
Useful investments: An S&P 500 Index Fund with a 0.35% expense ratio (ER), an actively managed small value fund with a 0.91% ER, an actively managed international fund with a 1.1% ER, and an actively managed bond fund with a 0.6% ER.

Account: Her 401(k)
Current balance: $50,000
Expected contributions: $17,500 per year
Useful investments: A total stock market fund with an ER of 0.1%, a total bond market fund with an ER of 0.1%, and a total international stock market fund with an ER of 0.15%.

Account: His Roth IRA at Vanguard
Current balance: $50,000
Expected contributions: $5,500 per year
Useful investments: All Vanguard funds available

Account: Her Roth IRA at Vanguard
Current balance: $50,000
Expected contributions: $5,500 per year
Useful investments: All Vanguard funds available

Account: Taxable account
Current balance: $100,000
Expected contributions: $19,500 per year
Useful investments: All publicly traded investments available; Vanguard funds available commission-free

The process of actually writing out your accounts and investments in this format is extremely useful. Be sure to evaluate your 401(k) or other employer-provided retirement account options so you understand what is available. Once you do this, you'll find the remainder of the process far easier. If you don't do it, it will seem impossible and possibly become very expensive if you have to hire someone else to help you do it.

 

Make Some Observations

Once you write down all this stuff, you can make a few observations.

Most, but not all, of the portfolio will be in tax-protected accounts. Within a few years, his 401(k) will be the largest account by far, with the taxable account the second largest. Her 401(k) has better investing options and lower expenses than his.

More information here:

The Importance of Asset Allocation

 

Principles of Asset Placement

There are a few basic principles to follow when going through this process. I'll list them here:

Taxable accounts should generally be filled with the most tax-efficient investments. Bonds generally go into tax-protected accounts, but it doesn't matter (or may even reverse) in times of lower interest rates. If placing bonds in taxable, compare after-tax yields to decide if municipal bonds are appropriate. Rebalance only in tax-protected accounts to avoid capital gains taxes. Take advantage of the best (usually lowest cost) investments in your employer's retirement plans, and build the rest of your portfolio around those. Keep in mind the effects of Roth vs. tax-deferred placement. (Placing assets with an expected high return preferentially into Roth accounts increases the risk of the portfolio on an after-tax basis and vice versa.) Keep future growth in mind when placing assets. Be sure at least one asset in each account is found in at least one other account to aid in rebalancing.

More information here:

My 2 Asset Location Pet Peeves

 

Implementing the Asset Allocation

How should our investor implement his allocation?

 

The Taxable Account

Since the taxable account is relatively large at $100,000, let's start there. We want to put tax-efficient assets into the taxable account preferentially.

Perhaps the most tax-efficient asset class is the international stocks. International stocks are slightly more tax-efficient than US stocks due to the foreign tax credit. Since the portfolio's overall value is $250,000, then the asset allocation calls for $250,000 * 10% = $25,000 in developed markets and $250,000 * 5% = $12,500 in emerging markets.

The next most tax-efficient asset class is probably the US stocks, although an argument could be made for using municipal nominal bonds. The asset allocation calls for $250,000 * 25% = $62,500 in US stocks. Since the taxable account has exactly $100,000 in it and since you need exactly $25,000 in international stocks, $12,500 in emerging market stocks, and $62,500 in US stocks, it fits perfectly. However, this violates principle No. 8. Perhaps a better option would be to put some municipal bonds into the taxable account. The asset allocation calls for $250,000 * 20% = $50,000 in nominal bonds. You could put all $50,000 into municipal bonds and then put the last $12,500 into US stocks.

 

The 401(k)s

 

His 401(k)

Let's leave the taxable account for a minute and move on to his 401(k). There is nothing in his account now, but clearly, the best investment option in his 401(k) is the S&P 500 index fund. As that fund grows, he's going to want his US stocks primarily in there. We know there will be a gradual transition of US stocks from the taxable account and perhaps another account over the years to his 401(k).

 

Her 401(k)

There is $50,000 now, and it will grow at a moderate rate. There is a great international option there, but we already have that covered in the taxable account. There is also a great US stock fund and a great US nominal bond option, similar to the taxable account. Perhaps using the total stock market fund will be the best option. Let's move on to the Roths.

 

The Roth Accounts

Both Roths have $50,000, and they will grow slowly with new contributions. This works out just fine right now to put $250,000 * 10% = $25,000 into each of the four remaining asset classes. Two could go into each Roth, and it would work out perfectly. It will make rebalancing difficult—due to the violation of principle No. 8—but since there are no tax consequences or investment expenses associated with rebalancing in Roth accounts, this can be worked out later.

 

This leaves us with an initial asset allocation plan that looks like this:

Total Portfolio: $250,000

His 401(k): $0
$0 in S&P 500 Fund

Her 401(k): $50,000
$50,000 into Total Stock Market Fund

His Roth: $50,000
$25,000 into Vanguard REIT Index Fund
$25,000 into Vanguard International Bond Fund

Her Roth: $50,000
$25,000 into Vanguard Small Value Index Fund
$25,000 into Vanguard TIPS Fund

Taxable: $100,000
$25,000 into Vanguard Developed Market Index Fund
$12,500 into Vanguard Emerging Market Index Fund
$50,000 into Vanguard Municipal Bond Fund
$12,500 into Vanguard Total Stock Market Fund

Is it perfect? No. Is it good enough? Absolutely. Another option that may be just as good, at least for now, is to put $50,000 in bonds into her 401(k) using the Total Bond Market Fund and putting all $62,500 allocated to US stocks into the Vanguard Total Stock Market Fund in the taxable account.

 

What Happens the Second Year?

Everything is perfectly balanced now, but what happens over the next year? This couple will be contributing $100,000 per year or about 40% of their current portfolio balance. Half of this will be going into his 401(k) with 5.5% into each Roth and nearly 20% into each of the two other accounts. Assuming no investment gains, the situation might look like this in a year.

Total Portfolio: $350,000
US Stocks: $350,000 * 25% = $87,500
Developing Market Stocks: $350,000 * 10% = $35,000
Emerging Market Stocks: $350K * 5% = $17,500
Small Value Stocks: $350,000 * 10% = $35,000
REITs: $350,000 * 10% = $35,000
US Nominal Bonds: $350,000 * 20% = $70,000
International Bonds: $350,000 * 10% = $35,000
TIPS: $350,000 * 10% = $35,000

This can be allocated like this:

His 401(k): $51,000
$51,000 in S&P 500 Fund

Her 401(k): $67,500
$24,000 into Total Stock Market Fund
$43,500 into Total Bond Market Fund

His Roth: $55,500
$35,000 into Vanguard REIT Index Fund
$20,500 into Vanguard International Bond Fund

Her Roth: $55,500
$14,500 into Vanguard International Bond Fund
$6,000 into Vanguard Small Value Index Fund
$35,000 into Vanguard TIPS Fund

Taxable: $119,500
$35,000 into Vanguard Developed Market Index Fund
$17,500 into Vanguard Emerging Market Index Fund
$26,500 into Vanguard Municipal Bond Fund
$12,500 into Vanguard Total Stock Market Fund
$29,000 into Vanguard Small Value Stock Fund

The portfolio is still balanced. It is certainly less than ideal to have a small value stock fund in a taxable account while a total stock market fund and nominal bonds (that could be muni bonds) are in a tax-protected account. But given the limited good options available in the 401(k)s, this is a compromise that has to be made to maintain the asset allocation. Another good option might have been to put more bonds into his 401(k) and more US stocks into the taxable account instead of the small value stocks. But you're weighing higher expenses against higher tax efficiency, and neither option is really ideal.

What had to be done during the year to get from our first setup to the second one?

In his 401(k), all new contributions went to the S&P 500 fund. In her 401(k), all new contributions went into bonds, and some of the stocks were sold to buy bonds. In his Roth, new contributions went into the REIT fund, and some of the international bond fund had to be sold to buy more REITs. There was no cost to that sale. In her Roth, new contributions went toward TIPS, and some of the small value stocks were sold to purchase TIPS and international bonds. In the taxable account, new contributions went into the developed markets fund, the emerging markets fund, and the small value fund. Some of the municipal bond fund was sold to purchase small value stocks. This is the only taxable event of the entire year, and given that it involved the sale of an asset which generally doesn't appreciate very rapidly, it would have very little tax consequence. As the ratio of new contributions to portfolio size falls, investors become less and less able to rebalance mostly with new contributions, and they'll have to actually sell assets more and more frequently. Try to avoid this in taxable accounts by selling assets with a loss first, then using new contributions, then using distributions (perhaps tolerating a little more imbalance than you would in a tax-protected account), and finally selling assets with a gain. In the end, you don't want the tax tail to wag the investment dog. The only thing worse than having to pay capital gains taxes to rebalance is not having to pay them.

 

I hope you found that demonstration helpful. The more accounts you have to deal with and the more asset classes in your portfolio, the more complex this process becomes. If you find yourself hitting your head against the wall while staring at your investments, remember that it could be worse.

Following this process will allow you to manage your own portfolio and save investment manager fees. Alternatively, if you choose to pay someone else to do this for you, you can understand what they ought to be doing in exchange for those thousands of dollars in fees. If you just need a little help, you'll find the Bogleheads willing if you can manage to complete the two prerequisites on your own.

What do you think of my principles of asset placement? Did I miss something? What else would you do? Do you have any tips for implementing and maintaining an investment plan? Comment below!

[This updated post was originally published in 2019.]

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