By Dr. James M. Dahle, WCI Founder


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


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


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Prerequisite #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 be able to 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 8 separate asset classes.  It is likely to meet an investor's goals if 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.


Prerequisite #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 out on paper.  For example, our investor may have accounts that look like this:

Total Balance of All Accounts: $250K
Total Contributions Per Year: $100K

Account:  His 401K
Current Balance: $0K
Expected contributions: $51K per year
Useful Investments: An S&P 500 Index Fund with a 0.35% 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 401K
Current Balance: $50K
Expected Contributions: $17.5K 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: $50K
Expected Contributions: $5500 per year
Useful Investments:  All Vanguard funds available

Account: Her Roth IRA at Vanguard
Current Balance: $50K
Expected Contributions: $5500 per year
Useful Investments:  All Vanguard funds available

Account: Taxable Account
Current Balance: $100K
Expected Contributions: $19.5K 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 401K or other employer-provided retirement account options so you understand what is available to you.  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.


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Make Some Observations

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

  1. Most, but not all, of the portfolio will be in tax-protected accounts.
  2. Within a few years, His 401K will be the largest account by far, with the taxable account the second largest.
  3. This investor is planning on maxing out all of his tax-protected accounts.  If he were not, he could live on some of his taxable account while deferring current salary into the tax-protected accounts.
  4. Her 401K has better investing options and lower expenses than his.


Principles of Asset Placement

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

  1. Taxable accounts should generally be filled with the most tax-efficient investments.
  2. Bonds generally go into tax-protected accounts, but it doesn't matter (or may even reverse) in times of lower interest rates.
  3. If placing bonds in taxable, compare after-tax yields to decide if municipal bonds are appropriate.
  4. Rebalance only in tax-protected accounts to avoid capital gains taxes.
  5. Take advantage of the best (usually lowest cost) investments in your employer's retirement plans, and build the rest of your portfolio around those.
  6. 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.)
  7. Keep future growth in mind when placing assets.
  8. Be sure at least one asset in each account is found in at least one other account to aid in rebalancing.


Implementing the Asset Allocation

So how should our investor implement his allocation?


The Taxable Account

Since the taxable account is relatively large, 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 value is $250K, then the asset allocation calls for $250K * 10% = $25K in Developed Markets and $250K * 5% = $12.5K 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 $250K * 25% = $62,500 in US Stocks.  Since the taxable account has exactly $100K in it, and you need exactly $25K in international stocks, $12.5K into emerging market stocks, and $62.5K into US stocks and it fits perfectly.  However, this violates principle 8.  Perhaps a better option would be to put some municipal bonds into the taxable account.  The asset allocation calls for $250K * 20% = $50K in nominal bonds.  You could put all $50K into municipal bonds and then put the last $12.5K into US stocks.


The 401(k)s


His 401(k)

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


Her 401(k)

Now let's look at her 401K.  There is $50K 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 $50K in them and will grow slowly with new contributions.  This works out just fine right now to put $250K * 10% = $25K 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 violation of principle 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: $250K

His 401K $0
$0 in S&P 500 Fund

Her 401K  $50K
$52K into Total Stock Market Fund

His Roth $50K
$25K into Vanguard REIT Index Fund
$25K into Vanguard International Bond Fund

Her Roth $50K
$25K into Vanguard Small Value Index Fund
$25K into Vanguard TIPS Fund

Taxable $100K
$25K into Vanguard Developed Market Index Fund
$12.5K into Vanguard Emerging Market Index Fund
$50K into Vanguard Municipal Bond Fund
$12.5K 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 $50K in bonds into Her 401K using the Total Bond Market Fund and putting all $62.5K 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 $100K per year, or about 40% of their current portfolio balance.  Half of this will be going into His 401K, with 5.5% into each Roth, and nearly 20% into each of the two other accounts.  So assuming no investment gains, in a year the situation might look like this:

Total Portfolio: $350K
Us Stocks $350K * 25% = $87,500
Dev Market Stocks $350K * 10% = $35K
EM $350K * 5% = $17.5K
Small Value $350K * 10% = $35K
REITs $350K * 10% = $35K
US Nominal Bonds $350K * 20% = $70K
International Bonds $350K * 10% = $35K
TIPS $350K * 10% = $35K

This can be allocated like this:

His 401K $51K
$51K in S&P 500 Fund

Her 401K  $67.5K
$24K into Total Stock Market Fund
$43.5K into Total Bond Market Fund

His Roth $55.5K
$35K into Vanguard REIT Index Fund
$20.5K into Vanguard International Bond Fund

Her Roth $55.5K
$14.5K into Vanguard International Bond Fund
$6K into Vanguard Small Value Index Fund
$35K into Vanguard TIPS Fund

Taxable $119.5K
$35K into Vanguard Developed Market Index Fund
$17.5K into Vanguard Emerging Market Index Fund
$26.5K into Vanguard Municipal Bond Fund
$12.5K into Vanguard Total Stock Market Fund
$29K 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 401Ks, 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 401K 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 set-up to the second one?

  • In his 401K, all new contributions went to the S&P 500 fund.
  • In her 401K, 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, 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 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 staring at your investments, remember it could be worse.  (I've got 9 accounts and 12 asset classes in my portfolio.)

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?  Right?  Wrong?  Did I miss something?  Do you have any tips for implementing and maintaining an investment plan?  Comment below!