One of the first steps in constructing a portfolio is to decide on an appropriate asset allocation for the portfolio. What percentage of the portfolio should be invested in stocks, bonds, and cash or cash alternatives? To a large extent, that allocation will determine the return and the volatility of the portfolio. The Wells Fargo Investment Institute calculates that over 70% of a portfolio’s return can be credited to the proper asset allocation. Stocks historically have generated higher returns than bonds, but with more volatility on an annual basis. The issue of volatility is a study in itself, but simply stated the question you must answer is - how much of a roller coaster ride are you willing to go on in order to generate your expected return?
In addition to deciding on a proper asset allocation for a personal portfolio, additional consideration must be given to the methods used to implement that allocation. For example, let’s say that you decide, based on your return expectations and your risk profile, you would like your portfolio to be balanced – 60% in equities and 40% in bonds. How do you go about structuring that balance? Do you allocate each of your accounts - each IRA, your 401(k), your non-retirement investment accounts – at a 60/40 blend, or do you only seek to assure that in the aggregate – in total – you are balanced 60/40. Experts weigh in on both sides, but many suggest that the tax treatment of the account should influence your decisions. I will also argue that the liquidity requirements for the account(s) must be taken into consideration, and are sometimes more important than the tax issues.
When I begin discussing the asset allocation process with clients, the first topic of discussion is the liquidity requirements for the money. When do they intend to use the principal? How much of the income that is generated will be utilized now? How much of the account, if any, will not be touched until after retirement? Those answers will often drive the asset allocation decisions. If, for example, the money is needed next year to make a tuition payment, then the appropriate asset allocation would not include any stock. While stocks generally outperform bonds over long periods of time, no one can predict the performance of the stock market over the short term. Longer term plans will often include an equity (stock) allocation. Deciding which accounts to use for the equity and bond investments is the next step in the process.
I will begin with a discussion of a recommendation that seems to be popular in some planning circles: that the bond component of a portfolio should be positioned in a (tax deferred) retirement account, and the growth portion of the portfolio – the stocks and real estate – should be held outside of tax deferred accounts. The reasoning for this suggestion is straightforward. Growth oriented investments like stocks can enjoy a tax advantage. If the holding period for the investment is long term, when the asset is sold it can be taxed at favorable long term capital gains rates. If the investment is directly in your name, you will garner that tax advantage. If, however, the asset is held in an IRA or other tax deferred retirement account, there is no immediate tax at the time of sale (the account is tax sheltered), but ultimately, when the money is withdrawn from the account, it will be taxed as ordinary income, not as a long term capital gain. In this example, you were penalized for holding the appreciated asset in a tax sheltered plan. Conversely, if the stock is sold at a loss in a tax sheltered account, the write-off cannot be utilized. Fixed income investments, such as bonds and CD’s, usually generate taxable income each year, so sheltering those particular assets in retirement accounts makes more sense, according to this strategy. There are always unique circumstances and exceptions (such as holding employer stock in a retirement plan), so you should always discuss your specific situation with your tax advisor. I will also discuss other, much more common, personal circumstances that might prompt you to consider an alternative strategy.
I mentioned earlier that the liquidity requirements for the money will often drive the asset allocation decision. Near term liquidity needs should preclude the use of stock for those funds. Historically the return on fixed income investments like bonds has not been competitive with equities over long periods of time, but the short term volatility of stocks make them unsuitable for short term commitments.
A conflict sometimes arises with investors who are trying to maximize the after tax return on these two asset classes (stocks v/s bonds), but whose long term accounts are limited to tax deferred retirement accounts. Take, as an example, a family who has $200,000 in personal investments: $100,000 is in a 401(k) retirement account, and $100,000 is in their investment account at a brokerage firm. The investment account will probably be used to fund college tuitions over the next three to five years. The couple wants to diversify their assets equally between equities and fixed income investments. A tax focused strategy would suggest that the tax deferred account – the 401(k) – should be used for the fixed income investments, to shelter the current income from the bonds, and that the stocks should be held in the brokerage account, to capture the capital gain tax savings when stocks are sold. That strategy, however, will be in direct conflict with the advice that stocks should only be used as long term investments – such as retirement nest eggs. In cases like this, I favor the liquidity concerns over the tax concerns. Any money that is needed over the next three to five years should not be invested in the market. Nobody can predict short term market returns.
An investor’s asset allocation should also be tailored to the net worth of the individual, since the value of the account will often influence how the distributions from the account are generated. As an example, wealthy investors with multimillion dollar retirement accounts are often capable of funding their retirement budgets from dividend income alone. No liquidation or drawdown of “principal” is required. In that situation, the time horizon for the capital in the account is still very long term. In essence, the retirees are really investing for the account beneficiaries, often their children. In situations like that, very high allocations of equities, even approaching 100%, can be appropriate, since “the principal” is not needed.
A more common planning situation is a retirement nestegg of less than $1,000,000, where the retirees must calculate “how long the money will last”. Proper planning will include a drawdown projection, using the retiree’s budget, and probable return estimates for the assets in the retirement account(s). In this scenario the time horizon is still longer than many people properly plan for, but it is not forever, and asset class volatility must be accounted for. An account that is 100% in equites would probably be inappropriate.
My point in this discussion is simply to illustrate that there is no magic formula, no “app”, or chart on a website that will determine your proper asset allocation. There are numerous personal considerations that are part of the calculation, and all must be taken into account. You have to be comfortable, and confident, that your investment plan, including your asset allocation - is the right one for you and your family. Part of that comfort level will come from being educated about the markets, and understanding that volatility and occasional negative performance is part of investing. Asset allocation can and should mitigate portfolio volatility, but it can never eliminate it. A properly balanced asset allocation should give investors participation in the long term rewards of equity investing with a level of volatility that they are comfortable with. Finding that proper balance is the key.
Wells Fargo Advisors did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors or its affiliates. This material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy and sell securities or instruments or to participate in any trading strategy. Wells Fargo Advisors does not provide tax or legal advice.
Past performance is no guarantee of future results. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets. Dividends are not guaranteed and are subject to change or elimination.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Bond laddering does not assure a profit or protect against loss in a declining market.
Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.