Host Jon Luskin, CFP® asks your questions to subject matter experts live.
You can get the dates and times for the next Bogleheads® Live by following the John C Bogle Center for Financial Literacy (@bogleheads) on Twitter.
You can see a list of previousBogleheads® Live episodes here.
Rick Ferri, CFA, fields live audience questions on asset allocation, discussing the difference between one’s investing philosophy and their strategy, how allocation drives investment returns, the value of rules of thumb when investing, how Rick’s approach to investing has changed over the years, factor investing, asset tax location (tax-efficient fund placement), and more.
Show N>Show Notes>
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Bogleheads® Live Tra>Bogleheads® Live Transcript] Jon: Thank you for joining us for the second Bogleheads® Live. My name is Jon Luskin and I’m the host for today. My co-host for today is Rick Ferri who for Bogleheads® needs no introduction. Rick publishes and speaks on investing and is the host of the Bogleheads® on Investing podcast. Today, we’ll be discussing asset allocation, with Rick having written the book on asset allocation, entitled “All About Asset Allocation.” For today, I’ll switch between asking Rick questions that I got beforehand from the various online Bogleheads® communities and getting questions from our live audience here today.
[00:52] But before that, let’s start by talking about the Bogleheads®, a community of investors who believe in keeping it simple, following a small number of tried and true principles. You can learn more at the John C. Bogle Center for Financial Literacy at boglecenter.net. And after three long years, the Bogleheads® conference is back. Mark your calendar for October 12th through 14th. More details will be announced soon.
Before we get started nerding out on investing a disclaimer, this is for informational and entertainment purposes only, and should not be relied upon as a basis for tax, investment or other financial planning decisions. Also, this session is being recorded with an edited version later being available on Bogleheads®.
Rick, let’s turn it over to you, and your book, All About Asset Allocation. John C. Bogle, founder and former CEO of the Vanguard Group, wrote that “All About Asset Allocation offers advice that is both prudent and practical. Keep it simple, diversify, and above all, keep your expenses low.”
From an author who knows how vital asset allocation is to investment success, and most important works with real people. That’s high praise, warranted of course.
[02:16] For my first question, what do Bogleheads® need to know about asset allocation?
Rick: What do Bogleheads® need to know about asset allocation? Well, thank you again for inviting me today. I’m your guest, I think this week and perhaps next week, and then you’ll have some other guests as well. I guess Christine Benz will be coming on Larry Swedroe. And a lot of other folks. I want to make sure that people who are listening know that I’m not just the only guest that you’re going to have. You’re going to have a lot of other guests going forward.
[02:45] But asset allocation, what do the Bogleheads® need to know? Well, asset allocation is part of the investment strategy that you have. And let me start out by talking about the three parts of an investment plan, if you will. The three parts of an investment plan are the philosophy of how you’re going to invest. You have the difference between passive investing and active investing. That’s the easiest way to look at it, where passive investors except the returns of markets as their return, without trying to think twice about it.
And then the active investors are trying to outperform the markets. And the philosophy of the Bogleheads® is to accept the return of the markets, whether it’s the bond market, the stock market, the CD market, the money markets, whatever it is. You accept the return of the markets as your return by doing an asset allocation of those markets for your own needs, which is strategy. And that’s the second thing.
[03:46] So you’re accepting the returns of the markets, but how should you do that? How should you mix your portfolio with these different asset classes of bonds and cash and stocks, based on your needs and your ability to handle risk. This is the strategy, the first level of strategy, which is what should your asset allocation be to achieve your goals within the framework of the amount of risk that you can take, or that you should take.
So it’s the need to take risk and the ability to take risk. So, the ability to handle volatility and whether or not you should actually go up to that level of risk tolerance, if you will, because a lot of people don’t need to be at a high level at their risk tolerance. They could be a lot further below it because they don’t need to take as much risk because they have accumulated the assets that they need.
So the first level of strategy is what portion of your portfolio should be in stocks. What portion should be in bonds? What portion should be in cash? This is what I call the layers of the cake. So, I like to think about asset allocation as a birthday cake. I know it’s a little strange, but a birthday cake. What’s the important thing about a birthday cake? Well, what’s important at the party is the candles, what everybody sings to and it’s the glow and then the frosting, and then what does the cake say? And all of that.
I mean, all this is very important. It sort of reminds me of the meme stocks and Coinbase and trading Bitcoin and all that. Those are the candles. I mean, that’s the party that’s going on in the markets. And that’s what we hear about. And everybody sings to it and all of that. But that’s not what’s important about the birthday cake. Because what do you do with the birthday cake when all of that is done, is you have to eat it? You bite into it. And then all of a sudden it’s like, either this is good cake, or this is not good cake.
It has nothing to do with the candles anymore. It has nothing to do with the decorations. It has to do with what you’re actually consuming. This is why asset allocation is important.
Asset allocation is the cake. It is the primary thing that people need to get right in their portfolios. They need to have the right amount of equity, the right amount of perhaps fixed income, the right amount of cash. This is what we consume. This drives 90% of our long-term investment performance, is the asset allocation.
It’s the cake. Even though we talk about the frosting and the icing on the cake and the decorations on the cake. Then we praise the candles when they’re lit and we sing to them, that stuff doesn’t matter. All that stuff we hear about, all that noise that we hear about out there in the media, doesn’t really matter. Day-by-day stuff doesn’t matter. That’s just candles; that’s just decoration.
[06:38] What matters to people’s portfolios is – the driving factor of how people will perform in their portfolio – is their allocation between stocks, bonds, cash. And I’m not counting things like real estate, which are not part of the public domain markets. Certainly, if you have a real estate that’s part of your asset allocation or private, you run a private company or something that’s part of your allocation as well. But this is just the public markets.
So, this is the major contributing factor to your long-term performance, is your asset allocation between these asset classes. That’s why it is so important for the Bogleheads®. And then once you have this asset allocation, we get to the third leg of the stool and that’s the discipline to stay with it. So no matter what happens with the markets, if they go up or down, you have to stay with the asset allocation or rebalancing once in a while, helps you keep that asset allocation.
It’s important, the discipline of maintaining that asset allocation in the very long term, drives your performance. If you take too much risk and you capitulate in a bear market, this is going to harm you probably at least as much as trading GameStop or something like that. It’s going to hurt you a lot in the long term. So you have to have the right allocation that you can stick with through all the market conditions. So this is the idea behind putting together an asset allocation in your portfolio, which is not above your tolerance for risk, and also has the right mix of stocks, bonds, and cash that you need for cash flow down the road in retirement.
[08:15] Jon: I love that cake analogy; successful investing is boring. For my next question, I’m going to make Cody Garrett a speaker and let Cody ask his question about asset allocation to Rick.
[08:32] Cody: My question for you, Jon, and you Rick is about asset allocation moving closer to retirement because I think a lot of us are thinking low-cost, long-term passive approach with decades to go before retirement. How do you start thinking differently whether using a total return rebalancing approach or a bucketing strategy when you get closer to retirement, let’s say five to 10 years out?
Rick: Okay Cody, thanks for joining us again today. Yeah, it’s a good question. I look at a bucketing approach myself. I mean conceptually, I think of it that way, as opposed to a fixed asset allocation. In other words, I’m looking for cash in a portfolio. How are the people going to get the income that they need for retirement? Where’s it going to come from? If it’s going to come from the investment portfolio, do we need to allocate a certain amount of the taxable portfolio that may have ordinarily new money?
Let’s say that they were investing in a taxable portfolio going now into fixed income so they can distribute that. How about in a tax-deferred account? How are we going to distribute money out of that account to get people the money that they need? So as far as changing the allocation, as you get closer to retirement, it depends. Everything of course depends. It’s a strategy, depends. Strategy depends on each individual.
[09:55] So there are some people who don’t need to change their asset allocation because they already may have fixed income in their portfolio because their accumulation allocation may have been 60% equity and 40% fixed income, or perhaps 70/30 or something where they don’t really need to make a big asset allocation change. And then you have people who have almost all equity. They they’ve been accumulating in all equity. And there you might have an asset allocation change to fixed income, or maybe not, depending on what the dividends that are coming off the equity are.
All I’m saying is it’s not these ideas of your age-in-bonds for example, and these rules of thumb. I don’t follow any of them. I just don’t follow any of them because every single person that I talk with has a different situation. They have a different tolerance for risk. They have a different family situation. They may be getting an inheritance in another year or two. I mean, everybody is different. So to say that once you get closer to retirement, you should start reducing your allocation to equity and start increasing your allocation to bonds doesn’t really hold water in reality.
That might be true for some people. That might not be true for other people. So, it’s not set in stone. It certainly isn’t a rule of thumb. I had a client today that I worked with who, and 90% in equity during their entire accumulation phase. And, of course, it’s helped them out greatly with this big bull market. Now they need to start distributing money out of their portfolio, starting on the beginning of next year. So we are going to be moving up to a 30% fixed income allocation from 10%.
So the equity will go from 90% down to 70%, and this will give them what they need, a cushion, if you will, for about five years until they start collecting Social Security. And then on top of that, the dividends that they have coming in from their other taxable portfolios will give them the cash flow that they need to live off of. So, there is sometimes an asset allocation change getting closer to retirement, and then sometimes there’s not an asset allocation change, but depending on each situation. And, then I’ll go one step for other and say, once you’re in retirement, there could be another asset allocation change.
And that is you realize you don’t really need to have that much in fixed income. And then you could do what’s called a reverse glide path, and you just let your equity continue to climb. And you don’t do any more rebalancing because it’s better for the estate. It’s better for the children or your heirs that you not do a rebalancing. And you let the equity portion climb higher, if in fact you don’t need all the money in retirement. So Cody, I guess the best answer for me is, “it depends.” It all depends on each individual case.
[12:52] Jon: Cody, thanks for her great question. Absolutely. It is personal. Certainly that rising equity glide path approach is a great way to manage risk. Holding a bunch of bonds at the outset of retirement is going to protect you in the event of that worst case scenario, that there is a market crash, just then that first year of retirement being the a riskiest day for any retirement plan. Holding a big chunk of bonds manages that risk. Now, of course, you don’t want to hold a bunch of bonds forever, because there’s long term inflation risk.
So the approach of this rising equity glide path, holding a bunch of bonds at the beginning, and then decreasing the amount of bonds throughout the course of your retirement, spending down those bonds, letting your stock portion of your portfolio drift upwards. That can be a great way to again, manage that market crash in the short term at the outset of retirement, but then also balance the risk of long-term inflation, impacting your wealth with that increasing amount of stocks managing that inflation risk.
[14:02] Cody: Jon, that was Michael Kitces and Wade Pfau wrote a paper about this. And I thought it was a good paper. If anybody wants to read it about reverse glide paths, it was written probably what five years ago, maybe even longer than that, about this very concept. It’s good stuff, if you had a chance to read it.
[14:17] Jon: Absolutely. Michael Kitces and Wade Pfau co-authored a paper together entitled “The True Impact of Immediate Annuities on Retirement Sustainability, A Total Wealth Perspective.” You can download that paper in its entirety for free on the SSRN.
Let’s jump to some of the various questions sourced for Rick online, All About Asset Allocation, from the various Bogleheads® communities.
Now, I received a lot of great questions, so thank you for everyone who submitted questions on those forums ahead of time. We don’t have enough time to answer all those questions. We can start with a great one that really jumped out at me and speaks to what the Bogleheads® are all about.
This is from username BoxerrumbleEJ257 on Bogleheads® Reddit and BoxerrumbleEJ257 asks, “since you literally wrote the book on asset allocation, is there anything you can think of that you would change or update in terms of advice?”
Rick: What is different with that book that I wrote probably 12 years ago, and now? Conceptually, the book is just as good today as it was 12 years ago with the idea is of looking for things that have varying correlations with each other. And I never use the word negative correlation or even no correlation because asset class correlations are dynamic.
This idea that you can get into an asset class, that’s going to be negatively correlated with stocks. If the market goes down, this asset class will always go up, is a fallacy. So I pointed out in my book years ago that look, there are even times Treasury bonds. I lived through the 1970s. I mean, the fact is Treasury bonds lost a lot of money and so in stocks. In fact, we’re seeing a little bit of that in the market right now, as Treasury bonds are losing money in stocks are struggling along this year.
So you’re seeing that they are correlated, but not the way we would want them to be. So it’s not always true that Treasury bonds are negatively correlated with stocks. So, these things are dynamic. It’s dependent on the period; period-dependency on these things. So what you have to do is you have to try to get three or four different asset classes together, and then hope that something in there is not acting negatively.
[16:32] And right now, the only thing that seems to be not acting negatively is cash and probably commodities in some way of some sort. But anyway, real estate of course has been doing very well too, so that hasn’t been acting negatively. But, the idea of the asset allocation book is to have a lot of different asset classes in your portfolio, so that when one isn’t doing, when stocks are not doing well, something else at least has the probability of bouying or holding up the portfolio. So, that over the long-term, you get this smoother ride.
So nothing’s changed in there. A lot of the book is all about that and that concept and getting across the concept, that there’s no such thing as a perfectly negatively correlated asset class, or even a asset class that has zero correlation because it doesn’t, it just varies. So your results are going to vary. So don’t be surprised if you thought you’ve put together the “optimal portfolio.” And it turns out not to be optimal, which was a surprise to many people I think during the financial crisis. It was like, “oh, optimization doesn’t work.”
Well, yes, it does work. It just doesn’t work all the time. It’s as optimal as it could be. Let’s put it that way. And I think that’s a lot of the message that I’m trying to get across.
So that’s what’s the same.
[17:40] What’s changed I think in the All About Asset Allocation book, is the number of individual securities that I’m now using. In the All About Asset Allocation book, I think I used eight, nine, ten different funds. For example, I divided Europe, Pacific, and emerging markets into three different pots of money. I was showing that there may be some benefit to having three different funds, rather than just having one total international fund.
I’ve gone away from that. Even if there is an incremental benefit to doing that, it’s much easier to have a total international index fund. If you are going to take a U.S. equity market and you want to slice it and dice it between, to add another element, sort of call it the icing on the cake. If you didn’t have the icing on the cake, which would be small cap value and real estate. If you didn’t have that icing on the cake, you’re just going to have the basic asset classes and you would have global equities and you’d have a bond fund of some sort, a total bond market. And you’re going to be there.
I mean, you could do this whole thing with two funds. A global equity fund and a total bond market fund. I mean, that’s all you really need. You could break it apart a little bit. And you could say U.S. stocks and international stocks, that seems to work better in a taxable account because you get foreign tax credits. So, I like breaking it apart between U.S. and international in a taxable portfolio. And, then as far as the bond side and the taxable portfolio, depending on what your tax bracket is, could be municipal bonds, could be taxable bonds.
I like to use I bonds as well. So that’s all within the basic materials of building an asset allocation, but then you can kind of build it up to maybe four, five, maybe six different funds if you call I bonds, a sector of the market, as far as your bonds, so you have a total bond market and then you have some I bonds. And then on the stock side, you have total stock and total international. If you want to put some icing on the cake, you can have some small cap value and maybe some REITs.
So the whole thing gets done with maybe 6 funds at the most. Instead of, I think in the book I had like 10, 12. So the thing that’s changed in the book is just, I think the number of stocks or the number of funds that I’m using, and that’s probably the biggest change.
[20:07] Jon: Absolutely. I’m also biased towards simplicity. If given the choice between a simple approach or something a little more complicated, I’m going to choose the simple approach, too. That’s why that Vanguard total world fund can be a pretty great way to get global diversification at ultra-low-cost. Of course, as Rick pointed out, you don’t necessarily want to do that in a taxable account, because then they’ll be losing that foreign tax credit.
However, in a tax-advantaged account, you don’t have that disadvantage. Also, you might pay a little bit more by not slicing and dicing a global stock allocation using VTI and VXUS, a total U.S. and a total international fund. Instead, however, it might make sense for some to pay just a tiny bit more, few extra basis points for the sake of simplicity.
Let’s jump to Rami’s question next. Rami, take it away.
[21:11] Rami: Okay. Thank you very much. I heard the last Twitter Space. It was wonderful. So I’m from Israel and my question is global. So, my stock location is global, which is fine. My question is regarding the fixed income, the bonds. So, typically you guys from U.S., you recommend global bond market, which is in dollars. However, my income is not in dollars. And do you have any guidelines how to view the fixed income in different currencies because on the one hand, if I take U.S. Treasuries, they tend to be less correlated to the global stock market because the U.S. is around 60% of the global stock market.
However, my paycheck is Israeli shekels, and the Israeli shackles got much, much, much stronger compared to the dollar, so I lost a lot of money by doing that. So I would be really interested to hear your opinion and also regarding whether you should choose Treasuries or just global international bond market or U.S. or whatever.
Rick: Well, thank you for the question. And I have to say, this is not an area where I’m an expert in. I do have a lot of inquiries from people all around the world, and a lot of people ask the same question. And, you should have your fixed income in your local currency or at least part of it. But other than that, I’m going to pass. Jon, do you have any comments or maybe people in the audience would be able to answer his question better than I can.
[22:43] Jon: That is certainly a fascinating question. The thing that I think about when designing a portfolio, figuring out how the different pieces are going to interact together. So with that reference, with that frame of mind, I’ve still come to the same conclusion as I would an investor in the United States, in that I’ve got the stock portion of my portfolio globally diversified at ultra-low-cost. And I want to find the investment that is going to be as different as possible from a global stock portfolio.
Now, when it comes to stocks, even though we’re globally diversified, a lot of the time, we’ll see all these stocks performing similarly, both U.S. and international, both large and small during market panics. And that’s to say, everything goes down during a market panic. Now one frequent exception to that is going to be United States Treasuries. So, it doesn’t necessarily matter if we’re living in the U.S. or not. Those U.S. Treasuries can still be a diversifier when it comes to those stock market panics. That’s one way to take a look at the question of, “Hey, how do I manage the risk of stocks?” Well, frequently Treasurers do best during those sorts of market panics.
[24:15] Let’s jump to a question we got from the online communities next. Rick, recently you had Eduardo Repetto PhD, Chief Investment Officer of Avantis Investors on the Bogleheads® on Investing podcast. For those who aren’t familiar with Avantis, they specialize in low-cost funds, providing factor exposure. Here’s a related question from whyme on the Bogleheads® forum. whyme asks, “in your interviews and writings, you have evolved from advocating for what you describe as complexity toward the Nirvana of simplicity as in your Core-4 portfolios.
“Yet, it seems like you still accept the academic research that once led you to advocate for factor tilts. Do you now believe that investors who accept that research and are prepared to say, of course should employ factor tilts?
Rick, before you answer that question, let me just share that this is referencing Rick’s Core-4 portfolios. Folks can check that out at Core-4.com and that’s where Rick provides simple model portfolios with different themes that folks can implement themselves at ultra-low cost. Let’s hear your answer on factor tilts. Rick, take it away.
[25:38] Rick: Well, that’s a great question. So you start out, the cornerstone of the portfolios are your total stock, your total international, a couple of bond funds. These are the cornerstones, the four corners if you will, of your portfolio. This is the cake, correct. Now, if you want a little icing on the cake, you want some flavor. Add some texture, if you will, to this core portfolio of total stock, total U.S. stock, total international stock, and a couple of bonds.
If you want the potential to maybe outperform the market and you are willing to wait 25 years or more to do it, to get it, to where you are that disciplined, you are that disciplined where you could put something like a small cap US value, whether it be Avantis or whether it be a DFA ETF, or some other very deep small cap value ETF. If you are going to add this flavor or this icing on the cake to your portfolio, you’re doing it because you’re expecting to get a higher rate of return over beta, over the rest of the market.
And theoretically you should. Why? Because of the podcast I did with Eduardo, who basically said, when you listen to the podcast, there is more risk in investing in small cap value companies or a basket of small cap value companies. And that is measured, the way they measure that is by what’s called the discount rate. So, people discount those funds more. Therefore, the expected return is higher because the discount rate is higher.
It’s no different than high-yield bond funds, for example. You’re expected to get a higher return from high yield bond funds because it’s more risk in a high-yield bond fund than there is in Treasury bonds. So, they have a higher yield and it’s the same thing here with these stocks. So, the stocks have a higher expected return. The market is saying they should have a higher expected return because there’s more risk. Whether it’s real risk, that’s measurable fundamentally or it’s behavioral risk where people just believe this. So they’re discounting the price of these stocks.
[28:05] If you put a big basket together of these stocks after you’ve gone through or filtered out all of the stocks on the market or all the stocks in the small cap marketplace where these factors are stronger, these value factors and quality factors are stronger. And the small cap space and then in the large cap space, and you go to the small cap space, because you’re not trying to get beta here. I mean, you’re trying to get something other than beta.
You’re trying to get a return other than the market. The market is already baked in. You’re trying to get something higher and you’re going to pay an extra fee to try to get that higher rate of return. So you get the most intensive small cap fund that you can find, which will not correlate with the stock market. And certainly as we’ve seen over the last 10 years, certainly has not correlated with the rest of the stock market. But that’s what you’re looking for, if you’re looking for this type of fund, with the intention of getting a higher rate of return, because in aggregate, you have all of these different stocks that have higher discount rate and therefore expected higher returns.
Now how long do you have to wait? How long do you have to wait to maybe get a higher return from this? And how long do you have to put up with sometimes very low returns relative to the rest of the market? And the answer is at least 25 years. That’s how long you have to wait. So yes, I believe in doing it. I have it in my own portfolio. But I’m never going to not have it in my portfolio. It’s not a trade. I’m not getting into it to hold it for a few years and then say, “oh, this isn’t really working out. I’m going to get out of this.” No, I’m not doing that.
[29:45] You have to put it in your portfolio because you believe in this whole idea of buying higher yielding securities, if you will, for the very long term, knowing that they’re going to be long periods of time when it doesn’t work, like we just went through one. And, then there are going to be periods of time where we have these bursts of incredible outperformance where these things go up by a hundred percent in a year or two.
And like they did from 2000 to say 2007. And then into the very long term, then if you’re rebalancing your portfolio with this in it, the equity portfolio would give you a slightly higher return than just owning the market.
How much higher? Well, I try to be realistic on this. What is the premium that I’m actually looking for? I’d like to get 2%, but let’s just call it 1% over the rest of the market. And let’s say that 25% of my stock portfolio is in small cap value. Therefore, a quarter of a percent. So I’m expecting my equity portfolio to outperform the market with this small cap value component by about a quarter of a percent over a 25 year period of time. I think if you’re going for anything more than that, then you’re being unrealistic.
[31:11] And if you don’t want to wait 25 years, then don’t do it. This is certainly something you don’t need. You don’t need this flavor, icing on the cake. You just go with plain vanilla, go with the total stock, go with the total international, be done with it. Don’t go for this extra quarter of percent return if you’re not going to hang onto it for 25 years. So that’s my view on it. And if you look at the All About Asset Allocation book, that was my view back then, that continues to be my view.
I don’t find a lot of clients actually need small cap value. I don’t bring it up to them, but if they bring it up to me, this is the conversation that we have. If you’re willing to stick it out for 25 years and you believe in this, then certainly you could put up to say 25% of your equity portfolio into small cap value. Other than that, don’t put any in because then it’s just a trade. So I hope that helps explain it.
[32:02] Jon: Absolutely. I love that. 25 years or more, I tell folks when it comes to targeting these factors be prepared for a lifetime of underperformance. Because, the moment you get tired of any factors underperformance, the moment you sell it, that is going to be the moment that it outperforms. So, you have to be ready to hold this thing forever. And of course, like all good Bogleheads®, you have to be pursuing the strategy at low cost.
Now again, the Avantis line of funds, they offer, what is probably one of the most competitively priced ways to access these factors.
Let’s jump to another question. This is from Mr. BB from the Bogleheads®.org online forums. And this is related. Mr. BB writes, what is the minimum fund holding percent that you need in order to have some overall value in a person’s portfolio: 5%, 7% to 8%?
Rick: Okay. What’s the minimum amount that you need, that you should have allocated to anything, to make it worth your while. I mean, I’ve seen asset allocation and optimize portfolios that have 1.1% in this fund, 1.3% in that fund, 2.4% in this fund. I mean, that’s kind of absurd. It really is. All that is, is complexity for the sake of job security. It’s just being overly complex. I wouldn’t invest in anything unless I was going to take at least a 5% position in it.
So if I’m going to do small cap value, it’s going to be at least 5% of my total portfolio. If I’m going to do real estate, it’s going to be at least 5% of my total portfolio. I’m not going to do 1%, 2%, 3%. I don’t see that as additive to anything except complexity. Just adds to complexity and maybe even adds to cost. But I hope that answers the question.
Jon: Absolutely. I agree. Anything less than a 5% slice of your portfolio is arguably meaningless and again, to your exact point only adds unnecessary complexity.
Let’s jump to Luke next for a live audience question, Luke, you are live to go ahead and ask your question about asset allocation to Rick Ferri.
[34:36] Luke: Hey I was curious, when it comes time to add bonds, is it suboptimal or a bad idea to just have this same asset allocation across all accounts? Or should you be putting bonds specifically into tax-advantaged accounts?
Rick: It’s a great question, Luke. Thank you for asking it. And let me just talk about the two different ways in which you could do this asset allocation. Let’s say you’re going have a 60% stock, 40% bond portfolio. How do you do it? You can either do it across-accounts. So you can do asset location, where you put the bonds, in general, the bonds go in the tax-deferred account because you haven’t paid any taxes on that yet. And eventually you will pay taxes on it down the road. And you put the stock and say the Roth accounts. And you put the stock in your taxable accounts, perhaps along with some fixed income as well, depending on what your cash needs are or the cushion that you need or the emergency fund you need in your taxable account.
So this is like a cross-account management for the purpose of doing asset location. It’s a great way of doing it, but it can also become confusing. It can become difficult when you’re trying to figure out how you’re going to distribute money in retirement. So the other way of doing it is a silo. Each of these different account types, tax-deferred accounts tax-free accounts, taxable accounts, all have their own 60/40 allocation. So, you only have to rebalance between each account.
And if you look at something like a Betterment, that’s generally the way they’ll do it. They’ll take each individual account and they’re going to just going to do the relocation or rebalancing within each type of account as opposed to trying to do it across-account. It does take a little bit of work to do across-account management.
[36:21] Now ,the other thing is if you’re going to do an account adjustment, an allocation adjustment, and you’re going to start adding more bonds, then if you do a cross-account management, then you simply take your tax deferred account and you take some stocks out of that and you put in bonds, there’s no tax consequence to doing that, so it’s very simple. But what if you’re going to do the silo approach for each one of these individual accounts, you’re going to lower your allocation to equity. So you start selling stocks in your taxable accounts. You could actually trigger a taxable event by doing it that way.
So from a tax standpoint, it is better to do a cross-account management, but it’s just more difficult to do it that way because you got to create a spreadsheet and you have to look at the spreadsheet and figure out, okay, how am I going to get this to, I want to go from 80/20, 80% stocks, 20% bonds down to now 60% stocks, 40% bonds. And how would I go about doing a cross-account management? And then you might run out of space. I mean, you may run out of space in your tax-deferred portfolio, so you don’t have any more space to put bonds.
[37:28] So then you have to go to your taxable account and you have to start adding bonds there. The last place you probably want to add bonds is your Roth account. But, that’s a general rule. I just had a client again today, this morning where we had a five years worth of cash basically or short term bonds going into the Roth account. Because as I explained last time, this particular client is going to be getting ACA tax credits for healthcare. So they are putting bonds in their Roth accounts so they can withdraw between 55 and 65 before they get on Medicare, taking part of the distribution from the Roth account plus dividends and interest from their taxable account to give them the money that they need to live on. And therefore, their taxes would be very, very low and they’d qualify for very high Affordable Care Act tax credit.
So as far as how you should do it, how you do it in your own portfolio. It’s a lot to do with taxes and doing cross-account management is certainly I think the most efficient way of doing it, the better way of doing it. But if that’s too complicated, they just do the silo approach where you have the same allocation in each of the accounts.
[38:39] Let me talk about something that I happened in, in the military. We had this thing called target fixation. But, what is that? Well, I used to be a fighter pilot. People who know me, know I flew fighter aircraft. And so we used to do a lot of target practice and we used to shoot guns at targets and missiles at target. So, we come roaring in on this 30 degree angle, throwing ourselves at the ground, shooting at these things. Once in a while we had mishaps and very bad mishaps because the pilots got target fixation. They would look at the target and they would concentrate on hitting that target so hard, they forgot to pull up.
And so, they ended up hitting the target, unfortunately. The target fixation, that can happen in investing as well. If you are doing the cross-account management approach, the asset location approach, you could start fixating on the performance of just one part of this portfolio. Like, “my gosh, my taxable account is doing so much better than my tax-deferred account. I need to add more stocks to my tax-deferred account.” Or, “oh my gosh, my tax-deferred account is doing so much better than my taxable account. I’m losing a lot of money in my taxable account. I need to lower risk in my taxable account.” In other words, you could lose sight of the big picture.
You lose sight of situational awareness, of the fact that you’re supposed to be looking across all these accounts when you’re doing your asset allocation. But, you get fixated on one account that’s not doing well. And you end up driving yourself into the ground because you do some sort of a market-timing maneuver that ends up not working on your behalf. I know it’s kind of a gory way of describing it, but this is the way I think about it when I’m talking about whether you should do the silo approach and if you’re prone to target fixation, or if you’re prone to just be focusing on each account individually and the performance of each account, then by all means do just have the same allocation in each of your accounts and don’t do across-account management.
But if you can see the big picture the 10,000 foot level and you don’t get all wrapped up around the performance of your taxable account or the performance of your Roth account or performance of your tax-deferred account. And you can see the big picture across the whole spectrum of the battlefield, if you will, then you should do across-account management. Sorry for the military analogy. Sometimes I do revert back to that.
[40:56] Jon: Absolutely. I tell folks the same thing you want to get that stock-bond mix right first. And then if you’re up for doing the additional work inside a spreadsheet, then go ahead and tackle that tax-efficient fund placement, that asset tax location strategy for that extra icing on the cake, if you will.
Well folks that is all the time that we have for today. So thank you again to Rick Ferri for joining us today. And thank you for everyone who joined us for today’s Bogleheads® Live.
Our next Bogleheads® Live will be on Thursday, March 31st at 4:30 PM Eastern time. We’ll be discussing fund selection with Rick Ferri. The week after that, we have Larry Swedroe discussing his new book on ESG Investing. Mark your calendars for Thursday, April 7th at 5:30 pm Eastern time.
Between now and then you can ask your questions on fund selection for Rick and sustainable investing for Larry on the Bogleheads® forum and at Bogleheads® Reddit.
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