In 1952, Harry Markowitz published a paper that changed the way investment portfolios are designed and constructed.
The revolutionary paper called “Portfolio Selection” introduced a theory called modern portfolio theory. Markowitz found that by constructing a diversified portfolio, an investor could take advantage of higher returns without having to take on an amount of risk above their risk tolerance.
An oversimplified way to describe modern portfolio theory is having a portfolio that holds assets that zig while the others zag.
Holding two stocks, for example, that are extremely risky (higher return) but have a negative correlation decreases the standard deviation (overall risk of the portfolio). How could adding another risky asset to a portfolio decrease the overall risk of the portfolio? The idea has everything to do with correlation.
While one stock is down, the other is up and vice versa. Diversification has become absolutely critical to portfolio management and is applied by considering asset classes, market exposure, global exposure, etc.
What Is Asset Allocation?
Asset allocation is taking assets in one account and assigning them to different asset classes.
For example, your risk tolerance might have you in an 80% stock and 20% bond portfolio. This would be asset allocation. Taking it a step further, you might have your stock allocated to specific percentages of different kinds of stock (i.e., U.S. Large Cap, U.S. Small Cap, International, Real Estate, etc.).
Your bonds might also be allocated to different subcategories, such as U.S. short-term bonds, global bonds, etc. The big picture is that you are diversifying your account into different assets, giving you exposure to assets that zig when others zag.
Choosing an asset allocation is extremely important. Consider reaching out to a financial advisor in Utah or Boise, ID, when choosing an asset allocation strategy. Aside from risk tolerance, an investor should also consider their goals when making such decisions.
What Is Asset Location?
Much different than asset allocation, asset location deals with types of accounts and where to put specific assets.
It’s important to understand three basic types of accounts:
- Taxable accounts.
Some common pre-tax accounts are 401(k)’s and traditional IRA’s. Contributions to these types of accounts are tax-deductible. Contributions can grow in the account tax-free, but distributions are taxed as normal income.
Some common tax-free accounts are Roth IRA’s and Roth 401(k)’s. These accounts do not get a tax deduction when making contributions. Contributions grow tax-free, and distributions are tax-free.
Taxable accounts include individual investing accounts, joint investment accounts, transfer on death accounts, etc. These accounts do not have an associated tax deduction, and growth in the account is taxed. Realized gains are taxed either at higher short-term capital gains rates (if held less than a year) or lower long-term capital gains rates (if held for more than a year).
Why Is This Important?
The simple answer is taxes.
Tax efficiency is actually very important to extending the life of a portfolio. If you own shares of a high yield bond fund, for example, you would never want to own those shares inside of a taxable account. The bonds would continually spit out income that is taxable.
In other words, placing a very tax-inefficient investment into a very tax-inefficient account is a bad idea.
Another example highlights how asset location can not only save on taxes but create more wealth for an individual.
Consider an investor who has a well-diversified portfolio split between three buckets: pre-tax, tax-free, and taxable. This investor places his riskiest assets, such as small-cap value and emerging markets, in his Roth IRA (tax-free). He does this because in the long-term, those asset classes yield the highest returns. Over his lifetime, the Roth has grown substantially, and he doesn’t need to pay taxes when taking distributions.
Although the example is simple, it illustrates how asset allocation can improve tax efficiency and increase a portfolio’s value.
Depending on what research you reference, tax allocation usually adds anywhere from 20 to 50 basis points to a portfolio.
Some investors may shrug this off, thinking that the value added is insignificant. But consider a portfolio of a retiree who has $1 million in their life savings. If we assume their portfolio needs to last for 30 years (which is a conservative assumption) and they earn a 7% return, the 50 basis points from asset allocation would mean an additional $1.1 million to the portfolio (future dollars) over that period of 30 years.
This example does not take into account distributions.
When it comes to long-term investing, even the smallest adjustments can have a powerful impact on your life savings. In the above example, the simple adjustment of where to place investment assets increased a portfolio by $1.1 million. It is incredible to think that something that simple can increase your wealth over the long term by so much.
Sometimes investors are disillusioned by complexity.
They believe that the secret to wealth is somehow obtained through solutions and strategies that are extremely convoluted and complicated. In pursuit of higher returns, investors chase complexity and, unfortunately, are often left out to dry. Leonardo da Vinci said, “Simplicity is the ultimate sophistication.” In the end, complexity cannot replace determination and hard work. Working hard to save is just one side of the coin. Investors also need to work hard and do everything they can to grow and preserve their wealth.
Not sure how to get started diversifying your assets based on allocation and location? Turn to TrueNorth Wealth. As a leading wealth management firm in Boise, ID, and throughout Utah, our team is here to help you achieve financial independence.