Mike over @ the Oblivious Investor blog sent out this post this morning regarding the application of asset allocation targets to multiple investment accounts. It addresses the question of whether or not an investor needs to apply an asset allocation target to each and every investment account they own (i.e. IRA, 401K, and brokerage account) or if they can view all the accounts holistically and apply the target to all of them as if it was one big portfolio.
In Mike’s opinion the latter is preferable because it allows the investor to shelter the gains in a tax-free account (i.e. IRA or 401K) and hold cash and fixed income investments in taxable accounts. Furthermore, he points out that it’s worth evaluating the expense ratios of various funds of the same asset class to see where the investor can reduce investment expenses.
To demonstrate he provides this example:
How about an Example?
Sarah has decided that she wants the following asset allocation:
- 40% U.S. stocks
- 30% International stocks
- 30% Bonds
She has $50,000 in a taxable account at Vanguard, $150,000 in a traditional IRA also at Vanguard, and $100,000 in her 401(k) run by Fidelity. (So her total portfolio is $300,000, and she wants $120,000 in U.S. stocks, $90,000 in bonds, and $90,000 in international stocks.)
Sarah has the following investment choices in her 401(k):
- Fidelity Capital & Income Fund (expense ratio 0.76%)
- Fidelity Small Cap Stock Fund (expense ratio 1.25%)
- Fidelity Select Health Care Portfolio (expense ratio 0.88%)
- Spartan Total Market Index Fund (expense ratio 0.10%)
- Fidelity Strategic Income Fund (expense ratio 0.71%)
- Fidelity Blue Chip Growth Fund (expense ratio 0.94%)
- Fidelity International Growth Fund (expense ratio 1.90%)
- Fidelity Total International Equity Fund (expense ratio 1.79%)
Sarah could implement her desired 40/30/30 allocation in each of her accounts, or she could implement that allocation for the portfolio as a whole.
The “Multiple Portfolios” Approach
If Sarah views each account as a separate portfolio and uses her 40/30/30 allocation in each one, her holdings might look something like this:
Taxable account:
$20,000 Vanguard Total Stock Market Index Fund
$15,000 Vanguard Total International Stock Index Fund
$15,000 Vanguard Total Bond Market Index Fund
Traditional IRA:
$60,000 Vanguard Total Stock Market Index Fund
$45,000 Vanguard Total International Stock Index Fund
$45,000 Vanguard Total Bond Market Index Fund
401(k):
$40,000 Spartan Total Market Index Fund
$30,000 Fidelity Total International Equity Fund
$30,000 Fidelity Strategic Income Fund
The “Single Portfolio” Approach
In contrast, if she looks at everything as a single portfolio, she could do something more like this:
Taxable account:
$50,000 Vanguard Total International Stock Index Fund
Traditional IRA:
$40,000 Vanguard Total International Stock Index Fund
$20,000 Vanguard Total Stock Market Index Fund
$90,000 Vanguard Total Bond Market Index Fund
401(k):
$100,000 Spartan Total Market Index Fund
Why is the Second Portfolio Better?
The second portfolio is an improvement over the first for at least a few reasons:
- It uses only low-cost funds, whereas the first portfolio has 60% of Sarah’s 401(k) invested in high-cost funds just to meet the 40/30/30 allocation in that account,
- It’s more tax-efficient because it places all of her least tax-efficient holdings (the bonds) in a tax-sheltered account, and
- It has only five moving parts to monitor rather than nine.
And Sarah’s situation is relatively simple. For investors with more accounts (especially married couples) or more complex asset allocations (i.e., more than 3 distinct asset classes), the complexity resulting from using the target allocation in each account can be significantly worse.
