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How to Clean Up a Portfolio

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:

  1. Is the overall asset allocation appropriate?
  2. Are there any opportunities to cut costs (including taxes)?
  3. 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.

Simplifying

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.

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Comments

  1. Howdy mike,
    I have to put a plug in here for Vanguard as well. While my fund choices are more numerous than yours so its a little more brain tease to rebalance Vanguard does make it pretty easy to see all the eggs at once.

    We have our accounts setup to be shared across each other. So when logged in to my account I can see all the stuff that is in my wifes account. It works that way for our newly established Individual 401 k with the Roth component.

    I can therefore see nearly all our assets from one account which works well for trying to follow the strategy you wrote, “implementing your desired asset allocation at the portfolio level (as opposed to in each individual account)”.

    Being able to see all the assets really helps me when I go to using Vanguard’s Portfolio Tester tool to see rebalancing scenarios. I can plug in numbers, add or remove funds and dollar amounts to get a good idea as to how I can rebalance.

    Outside Assets do not show up in the shared views. No big deal for us as the only ones we have are 2 IBonds.

    W/ regard to lowering 401 k costs…geez I am not sure you can get any lower costs than Vanguard. I think the cost is $0.00 because we are Voyager.

    I really like your simple portfolio Mike and a more simple one for us certainly is in our future. My biggest concern is making it plum easy for my wife in case I get hung up in a stirrup, dragged through a rock pile, and end up pushing up daisies. :-)

    I’ll have to think a little more on the last paragraph in your posting and see how we fit there.
    Thanks Mike!
    Happy trails!

  2. Maybe I am looking at my own situation a bit too much, but there should be something in there for person’s intent. Maybe they aren’t looking into tax efficiency too much right now so they have access to the income stream way before 59.5 (ignoring 72 distributions)?

  3. Hi, Mike. We’ve gone over this several times with regards to my portfolio, and I suppose the only difference from all the above is that I keep more funds than you would. But I think that keeping most of my traditional IRA assets with Vanguard – 9 funds in total, with several bonds funds (TIPS, short/term, and Total); most of my stocks in the Total Stock and Total International; and small quantities each in a REIT, Precious Metals, and Small Cap tilts in both domestic and international – is not unnecessarily complicated. I remember you saying that you wouldn’t want to maintain so many funds, but in fact I find there’s little maintenance needed or involved, as I have small enough quantities in each of the last four funds that they rarely fluctuate beyond my targets. Otherwise I keep my Roth in the Vgd Balanced Index fund, which is nothing more than 60% Total Stock + 40% Total Bond, and I keep my 401(k) in the Fidelity Spartan Total Stock, which is identical to Vanguard’s parallel fund.

    One point you don’t mention (and it’s not even covered in the Bogleheads Retirement book) is the ability of investors over 59 1/2 to consolidate by doing an in-service rollover from a 401(k) to a traditional IRA. This is allowed by the IRS but not all 401(k) plans, or may be allowed with restrictions (fortunately my plan has none). So let’s say (because it’s true) I right now have 5% of my portfolio in the Fidelity Spartan fund, I can easily rebalance by periodically taking that amount every year or two and moving it to one of the Vanguard bond funds, thus letting me allocate more conservatively as I plan to do the closer I reach retirement age.

  4. Evan and Larry,

    Yes, you’re both right that for various reasons this general framework may need to be adapted in any of several possible ways.

    To the situations you’ve mentioned, I’d add the situation in which the investor already has a fairly tax-inefficient holding in his/her taxable account with a very large unrealized capital gain. In some such cases, it might make sense to just keep it where it is rather than selling it in order to achieve more tax-efficient fund placement.

  5. Mike,

    I see attorneys do it ALL the time when it comes to estate planning – they focus a bit too much on tax efficiency and completely by-pass the question, “What do you want to happen to all your stuff?” I think intent and desire should be the first question then you move into asset allocation, tax efficiency, etc.

  6. The Bogleheads Guide to Investing p121 says “Total International fund is best placed in retirement accounts” because of Total International does not qualify for foreign tax credit. Is this just an exception -and Total International should be held in a retirement account?

  7. We are doing this. Only 5% of our retirement investments are at my husband’s new 401k, and the remainder is in our IRAs (he has a Roth and a traditional; I have a Roth).

    We chose the investment with the lowest fee at the 401k, and allocated it all there. It happened to be a large cap American mutual fund.

    But soon, we expect the 401k to have a greater weight so we’ll have to consider if it would be better to move it around.

  8. Kelly,

    Good question. That’s no longer true. It was true at the time because it was a “fund of funds” and because, at the time, such funds didn’t qualify for the credit because they don’t actually pay foreign taxes — the underlying funds pay them. A couple of years ago though, Vanguard’s Total International Stock Index fund changed so that it now directly holds stocks. In addition, the Regulated Investment Company Modernization Act of 2010 changed the rules so that funds-of-funds can now qualify to pass the foreign tax credit on to their shareholders.

  9. “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.”

    I see the advantage of that, but I feel there are two issues that might be worth thinking about before putting everything into one brokerage:

    1) Will it raise your costs?
    Here in Sweden it seems there is no brokerage/bank that has competitive prices on all different kinds of investments: some have low dealing fees for shares but don’t sell bonds, one bank has a low dealing fee for bonds (and allows purchases in small amounts) but has a very poor selection of funds, and so on. So if I want to buy bonds directly (which I do) but also invest in a low-cost stock index fund, I more or less have to have two accounts.

    Remember, a small percentage increase in costs compounds to a large reduction in the size of your investment over a long period of time.

    2) Are you willing to take the counterparty risk?
    A question few people would ask (including me) until MF Global lost some of its customers’ funds. Yes, the risk of losing some of your investments through incompetence or criminality at a brokerage is small, but it is not non-existant. And (at least in Sweden) the investor protection scheme that insures you against this risk does not cover very much (only 250 000 SEK).

  10. Niklas,

    I’ll defer to Mike’s greater knowledge, but here in the USA, the Vanguard group stands out for offering a wide variety of investments at very low expense ratios. Perhaps the only obvious lacunae are funds for commodities and micro-caps, but these are not essential and can be covered elsewhere if desired. Here also, I’m not aware of any investor protection mechanism that insures against risk. The victims of the Bernard Madoff fraud scheme were not insured in any way, and have been left to recover whatever they could through the criminal prosecution process.

  11. Niklas,

    At least for passive investors in the US, as Larry said, it’s hard to find anything where you’d get significant cost savings by using a company other than Vanguard.

    With regard to risk taken on by using only one fund company, here’s what I’ve written before, which still states my understanding of the situation:

    I’m not really worried about having all of my money with one company. My understanding is that neither the demise of Vanguard, nor the demise of JPMorgan Chase (the custodian of the Vanguard fund I use and I believe of most Vanguard funds) would have a particularly detrimental effect on my holdings.

    There’s a possibility that JPM would engage in some sort of fraud (e.g., reporting that they have all the assets they’re supposed to have, when really they’ve siphoned some off in some way) and that the fund’s auditor (PWC) wouldn’t catch it. But I don’t think that type of risk is necessarily mitigated by using multiple fund companies.

    Similarly, there’s the possibility of fraud at the Vanguard level (e.g., accepting my cash and my buy order, then never relaying that order to JPM) and that PWC would miss it. But again, I’m not really sure that that risk would be meaningfully reduced by using multiple fund companies.

    That said, I think rational well-informed people could come to the opposite conclusion as well.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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