I’ve written several times about how much I enjoy the Bogleheads forum. While there’s a wide variety of investing-related discussion there, my favorite posts are the simple nuts and bolts ones in which an investor outlines his/her portfolio and other forum members give feedback.
I think it’s fun to see a jumbled mess of a portfolio get cleaned up into something that’s more diversified, lower-cost, and easier to manage. That’s why, when I’m checking out a portfolio, there are three questions I seek to answer:
- Is the overall asset allocation appropriate?
- Are there any opportunities to cut costs (including taxes)?
- Are there any opportunities to simplify?
When answering these three questions, it’s important to remember is that it’s all one portfolio. By implementing your desired asset allocation at the portfolio level (as opposed to in each individual account), you often create opportunities for cost savings and simplification.
Checking the Asset Allocation
As we’ve discussed before, asset allocation is not a precise sort of thing (nor, for that matter, is the concept of risk tolerance, on which an investor’s allocation should be based). As a result, for a given investor, there are countless possible allocations that could be acceptable.
So, for the most part, this step is just a quick check to make sure that there’s nothing that’s clearly wrong (such as a very large allocation to one individual stock or an extremely stock-heavy allocation when the investor has provided no information that would indicate that he/she has a super-high risk tolerance).
Cutting Costs: Start with the 401(k)
When searching for cost saving opportunities, the first place to look is your 401(k). The reason to start here is that all your other accounts (that is, IRAs and regular brokerage accounts) can be held at your brokerage firm of choice, thereby giving you access to low-cost investments in each asset class in these accounts, whereas you don’t always have great options in a 401(k).
So we start with the lowest-cost fund in the 401(k) and allocate as much as possible to that fund without messing up the desired overall allocation. For example, if:
- an investor’s 401(k) makes up 25% of her portfolio,
- the lowest-cost fund in the plan is a diversified U.S. stock fund, and
- her desired asset allocation necessitates holding 30% of her portfolio in U.S. stocks,
…then we’d allocate the entire 401(k) to that U.S. stock fund, and then use the other accounts to fill in the other necessary portions of the desired allocation.
In contrast, if we change the above example so that the investor’s 401(k) made up 40% of her total portfolio, then we would no longer want to allocate the entire 401(k) to the U.S. stock fund (because she only wants 30% of her portfolio in U.S. stocks). Instead, we’d allocate 3/4 of the 401(k) — or 30% of her total portfolio — to that fund in order to achieve her desired U.S. stock allocation. Then we would look for the next-lowest-cost fund in the plan and proceed from there.
Cost Savings: Tax-Efficiency
After doing everything possible to use low-cost investment choices, the next way to look for savings is to try to make things as tax-efficient as possible. The overall goal is to tax-shelter your least tax-efficient assets (REITs, high-yield bonds, and other taxable bonds) by putting them in your tax-sheltered accounts (IRA, 401(k), etc.) before tax-sheltering your more tax-efficient assets.
For most index fund or ETF portfolios, the most tax-efficient asset class is international stocks, so if you only need to leave one asset class in a taxable account, that’s likely to be your best bet.
With regard to simplification, the first and most obvious step is to minimize the number of accounts involved — combining all your non-401(k) accounts at one brokerage firm. (Personally, I like Vanguard. But they’re not the only good choice.)
The next step is to work to reduce the number of funds involved. In many cases this means using just 1 or 2 funds in each account, with the exception of one account (often the biggest one) in which you would hold each asset class and in which the necessary rebalancing would take place to keep the entire portfolio in line with the desired allocation.