Simplifying Asset Allocation, Location and Tax-Efficient Investing
What is Asset Allocation?
Asset allocation is the process of dividing your investment portfolio among different asset classes, such as stocks, bonds, and cash. The goal of asset allocation is to balance risk and return. By investing in a variety of assets, you can reduce your overall risk while still aiming for a reasonable return on your investment.
How to choose your asset allocation
There are a few factors to consider when choosing your asset allocation, including:
Your risk tolerance: How much risk are you comfortable with? If you're not comfortable with a lot of volatility, you'll want to allocate more of your portfolio to bonds and cash.
Your time horizon: How long do you have until you need to use your money? If you have a long time horizon, you can afford to take on more risk. If you need your money in the near future, you'll want to allocate more of your portfolio to safer investments.
Your investment goals: What are you hoping to achieve with your investments? If you're saving for retirement, you'll want to allocate more of your portfolio to stocks. If you're saving for a short-term goal, such as a down payment on a house, you'll want to allocate more of your portfolio to bonds and cash.
Once you've considered these factors, you can start to choose your asset allocation. There are a number of different asset allocation models available, or you can create your own.
For example – if you have an aggressive risk tolerance, a 10+ year long time horizon, and your investment objectives are “growth” then you might have an asset allocation that is 90% stocks and 10% bonds/cash. This allocation will experience greater volatility during market up/down swings, but over a long enough time horizon could expect a higher return than a portfolio with 60% stocks and 40% bonds/cash.
Here is a breakdown of common asset allocations, and their respective investment objectives:
100% Stocks / 0% Bonds – Very Aggressive
80% Stocks / 20% Bonds – Aggressive
60% Stocks / 40% Bonds – Balanced
40% Stocks / 60% Bonds – Moderately Conservative
20% Stocks / 80% Bonds – Conservative
0% Stocks / 100% Bonds – Very Conservative
Asset location
Asset location is the process of allocating different asset classes to different types of accounts, such as taxable accounts, tax-deferred accounts, and tax-free accounts. The goal of asset location is to minimize your overall tax liability.
For example, you may want to allocate more stocks to your taxable accounts and more bonds to your tax-deferred accounts. This is because stocks typically generate less income than bonds, thus creating lower tax liability in a taxable account. Bonds and cash tend to generate more income that could be taxable, so sheltering this income in a tax-deferred account could help reduce having to pay taxes on that income each year.
Note that one significant downside to asset location strategies, comes when investors need a withdrawal from their taxable account. Because withdrawals from tax-deferred accounts typically come with steep taxes & penalties, most investors first go to their taxable accounts for a withdrawal. If the taxable account is only comprised of equities, the account could present a higher risk profile when the investors needs their withdrawal. Imagine finding a perfect home to buy for your family, only to have the market nosedive when you need to withdraw your down payment. Furthermore, by only withdrawing from the taxable account that holds equities, this can impact the overall allocation across all accounts.
Tax-efficient Investments
When choosing investments for a taxable account, it is important to consider the tax implications. There are a number of different investments that can be considered tax-efficient. Some of the most common include:
Direct indexing: Direct indexing is a type of investment that allows you to track a specific market index, such as the S&P 500, by purchasing the 300-500 individual stocks that make up the index. The direct index provider will then tax-loss harvest individual stocks when they drop in price, allowing the investor to write off realized capital losses. For example – say you are invested in T-Mobile and the stock drops 10%, you can sell T-Mobile to realize the loss and purchase Verizon stock. This maintains the same risk/reward/sector allocation, while allowing the investor to write off the loss on T-Mobile shares.
ETFs: ETFs are a type of investment that tracks a specific market index or basket of assets. ETFs can be a tax-efficient way to invest, as they typically don’t have high turnover or transactions typically found in mutual funds. As an added bonus, ETFs also often have low expense ratios when compared to mutual funds.
Municipal bonds: Municipal bonds are bonds issued by state and local governments. The interest income from municipal bonds is typically exempt from federal income tax and may also be exempt from state and local income tax. Let's assume an individual is in the highest tax bracket, which has a federal tax rate of 37% and a state tax rate of 0%. They are considering investing in a municipal bond that offers a tax-exempt yield of 4%. To calculate the tax-equivalent yield, we can use the following formula:
Tax-Equivalent Yield = Tax-Exempt Yield / (1 - Tax Rate)
Tax-Equivalent Yield = 4% / (1 - 0.37) = 4% / 0.63 ≈ 6.35%
Conclusion
Asset allocation is an important part of any investment portfolio. By carefully considering your risk tolerance, time horizon, and investment goals, you can create an asset allocation that is right for you.
Asset location can also help you minimize your overall tax liability. And by using tax-efficient investments, you can further reduce your tax burden.
DISCLOSURES:
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
All investments include a risk of loss that clients should be prepared to bear. The principal risks of CWA strategies are disclosed in the publicly available Form ADV Part 2A.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.
