All too often, financial advisors, investors and 401(k) managers fixate on asset allocation — the proverbial pie chart depicting the percentage of stocks, bonds, cash and even alternative investments. This focus on mitigating investor vulnerability to volatility via diversification tends to dominate any conversations about portfolio construction.
We’ve all been indoctrinated in the traditional asset allocation based on Harry Markowitz’s Nobel Prize-winning Modern Portfolio Theory, which mathematically concluded that a portfolio of non-correlated assets would yield better long-term returns because of the volatility smoothing it offered versus an individual asset. Based on this premise, most human and robo-advisors utilize a risk profile to determine whether an investor is conservative, moderate or aggressive, then select the appropriate mathematical allocation in stocks, bonds, cash, alternatives, etc.
But in working with high-net-worth clients, my firm recognized long ago that the often-overlooked aspect of “location” can play a vital role in the actual wealth-building (and protection) outcomes, based on three complementary considerations.
Location, Part 1: Whose Balance Sheet Owns the Investment?
The first consideration is the legal ownership of an asset, which typically dictates not only who can make decisions about it, but also tax implications and beneficiaries in scenarios such as death or dissolution. Is it owned by one party of a household, by the children or perhaps through a trust or in a 529? This is an important concept, because locating assets inside ownership structures that create protections against creditors and predators can provide significant advantages when trying to build and preserve long-term wealth.
Investors tend to focus on the fees they pay to an advisor, fund or management company. However, the vehicle being utilized, such as real estate, an IRA, annuity, brokerage account or mutual fund, often influences the overall cost of its success, also known as tax burden. Sometimes, taxes wind up being the greatest cost associated with an investment, amounting to 20-50% of the total appreciation.
Owning an asset personally, versus doing so jointly or in a trust, can greatly impact tax liability. Such distinctions equate to benefits and value propositions that have little to do with the overall asset allocation of a portfolio, but we find that most investors are unfamiliar with this type of thinking and miss the opportunity to protect their hard-earned investments from unnecessary fees and exposures.
Location, Part 2: What Is the Vehicle Holding the Investment?
The second aspect is the type of vehicle that an asset is invested in. Is it taxable, tax-deferred or tax-free? For example, an IRA is often tax-deductible for contributions, but tax-deferred for growth and taxable on exit. An investment with this type of structure can potentially be impacted by many different decisions affecting taxes one way or another. As a result, some investments are better structured for such a vehicle than others.