Designing Your Portfolio- Part 6 (Implementing The Asset Allocation)

At this point, you should have developed an asset allocation for your portfolio.  To learn more about that, go back to the previous parts of this series.

It’s now time to implement the asset allocation.  This involves not only selecting the actual investments to fulfill the asset allocation, but also deciding what types of accounts to use and determining where you should locate each investment within those accounts.

Selecting Investments

You’ve basically got three choices when you select investments.  You can select individual securities yourself, or you can pay someone else to do by investing through traditional mutual funds or ETFs.  If you pay someone else, you can have them manage the investment actively (trying to beat the market), or have it done passively.  I favor passively managed mutual funds for three main reasons:


First, it turns out that active management is really hard.  If this is news to you, I suggest a quick read of Rick Ferri’s The Power of Passive Investing.  He puts together academic studies done over decades that demonstrate that while beating the market is possible, it is highly unlikely, and becomes more unlikely the longer the investing time period and the more investments that need to be selected.

Second, active management is really expensive.  In fact, that’s a big part of the reason why passive funds outperform active funds.  (The other big reason is primarily behavioral.)  Years ago, the only funds available were actively managed.  That provided a benefit to investors since they could get wide diversification at a much cheaper price than they could get themselves.  There was little focus on “beating the market” since you couldn’t buy the market.  When index funds showed up, other mutual funds had to focus on beating the market, and it turned out it was much harder to do than anyone imagined.  The expense ratio on funds easily available to any investor is less than 0.1% per year, or less than $1 per $1000 invested.

Third, passive management is really easy.  You select a fund based on only three factors: which index does the fund follow, how well does it do so, and at what price.  You don’t have to learn all about the manager’s background, evaluate his track record, and constantly monitor his activity so you can get out quickly if he ever “loses his touch.”  You just buy it and forget it.  Passive investors get mad when their fund doesn’t have a return within a few basis points of the benchmark index, which is a pretty rare event for most popular index funds.

Some people spend a lot of time worrying whether to use traditional index mutual funds or the newer ETFs.  The truth of the matter is that it doesn’t matter all that much.  Expenses are similar and true advantages of one over the other for most investors are minimal.  Mutual funds are generally easier to use since you don’t have to interact with the market, but in some of the more obscure asset classes an ETF is markedly better than a fund.

The process for most of us goes like this:  If I want say 5% of my portfolio in REITs, I look for a passively managed REIT fund and put 5% of my portfolio in it.   I want 5% of my portfolio in emerging markets, so I look for the best passively managed emerging markets fund and put 5% of my money in it.  It’s pretty simple.  If you’re not sure where to start looking for passively managed funds, go to Vanguard.  You don’t necessarily have to have all your investments at Vanguard, but you probably ought to have a pretty good reason to invest somewhere else.

The hard part is the asset allocation, not the selection of the investments.  But too many people don’t do these steps in order, and that’s where things seem confusing and complicated.

Choosing Accounts

This step can make a big difference.  I’m often surprised to see people not using the appropriate type of accounts for their situation.  For example, a resident who isn’t investing for retirement in a Roth IRA.  Or parents saving for their children’s college in a taxable account instead of their state 529 plan.  Or a doctor at the peak of his earnings career choosing a Roth 401K or even a taxable account instead of maxing out his tax-deferred 401K contributions.  Everyone’s situation and outlook is a little different, but using the right accounts for the right reason can make a huge difference in your after-tax returns over the years.

Tax-Efficient Placement

If all your investing accounts are tax-protected (like mine currently are) this step doesn’t matter so much.  If you have a significant taxable investing account however, you need to pay attention to this step.  As a general rule, you should use tax-protected accounts as much as possible, and when you have to invest in a taxable account, you place your tax-efficient assets there first.  So if only 50% of your investments are within tax-protected accounts, and your desired asset allocation is:

  • 20% Total US Stock Market
  • 20% Total International Stock Market
  • 20% Small Value Stocks
  • 5% REITs
  • 15% TIPS
  • 20% Total Bond Market

Then you’d want to rank the assets in order of tax-efficiency.  Here’s that list in order from most efficient to least efficient:

  • Total International Stock Market
  • Total US Stock Market
  • Small Value Stocks
  • REITs
  • Total Bond Market
  • TIPS

So you would then place your assets like this:

Tax-protected accounts 50%

  • 15% TIPS
  • 20% Total Bond Market
  • 5% REITs
  • 10% Small Value Stocks

Taxable account 50%

  • 10% Small Value Stocks
  • 20% Total Stock Market
  • 20% Total International Stock Market

There are a few subtleties to this process, but in general it’s pretty straightforward.  If you’re not quite sure you’re doing it right, consider posting your desired asset allocation and how you’re planning on implementing it on the forum at Bogleheads.org.  You’ll have valuable feedback within minutes and some reassurance that you’re doing it right.  Next time, in the final post of this series, we’ll discuss maintaining the portfolio as the years go by.

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Comments

Designing Your Portfolio- Part 6 (Implementing The Asset Allocation) — 6 Comments

  1. I don’t hold small value in a taxable account. A certain portion of the expected additional return of a small value portfolio would be eaten up by the additional tax cost, but none of the additional risk would.

    After-tax (and after-expenses since small value funds are more expensive than a total market fund) how confident am I that it will outperform a broad index fund over the long-term? I guess I think it is more likely than not, but certainly not a “no-brainer.” Total market investing is a perfectly reasonable approach, especially in a taxable account.

  2. For tax efficiency and overall portfolio, you outlined in another post that contrary to Boglehead theory, an investor is better off with stocks in tax sheltered accounts (IRA, 401k) and bonds in a taxable account. My question is should a high tax bracket investor simply put all of their bonds in munis such as VWITX (Vanguard Intermediate Term Tax Exempt)? Or would one be missing out on the broader and diversified bond market?

    • The point of the other article is that bonds often are better in taxable, although at current rates, perhaps not by much. Asset allocation generally trumps asset location. If your asset allocation calls for a certain percentage of inflation-linked bonds, and you couldn’t buy enough I bonds, I’d buy TIPS in the tax-protected accounts, asset location be damned.

      That said, I think Vanguard intermediate term tax exempt is just fine as a sole nominal bond holding. If your plan doesn’t call for inflation linked bonds, I think that would be fine as a sole bond holding. If you want more diversification, then put some corporates or treasuries into your tax-protected accounts and some very tax efficient stock index funds into taxable to make room. It’s all a trade off here, of course. More diversification for perhaps a bit less tax efficiency.

  3. Appreciate your response and your wonderful blog. I have found it much more useful than my local financial advisors who have very little training.

    Do you recommend practicing target AA in all your accounts. For example, if my target AA was 80% stocks and 20% bonds should I have that AA in my ROTH IRA, 401k, 403b, and taxable account? Or should I put mostly stocks in tax sheltered accounts and munis in the taxable?

    Thanks for all you do!

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