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Asset Allocation & Asset Location

The correct Asset Allocation is one of the most important factors—if not the most important factor—in your investment decisions. Think of it this way, if you were making apple pie you would never forget the apples. Following the pie analogy, once you have the apples, the pie is then influenced by the type, ripeness, and quality of the apples you choose to put into it but the apples are the key. We diversify and build our portfolio recommendations based on the asset allocation, which is simply the breakup of how much of our portfolio is invested in the three main asset classes: equities (stocks), debt (bonds), or cash. Then, within each of those we can break down our asset allocation even further. The Morningstar Style Box has become the “go-to” tool to categorize the asset allocation of equity and debt investments and it looks like this:










Looking at the above, here’s how it breaks down for U.S. equities (stocks):

  • From top to bottom: Large Capitalization (a.k.a. large U.S. companies), Medium Capitalization, and Small Capitalization.

  • Why are these significant? Because there are different risk/potential return profiles for larger vs. smaller companies. Larger companies are obviously more established and typically less volatile in the short-run; however, they have a smaller potential return in the long-run. One reason for this is because a small company can typically double its revenue from $100 million to $200 million much easier than a larger company can double its revenue from $20 billion to $40 billion; however, a small company is also much more likely to go bankrupt than a large company. Because of that, and depending on a person's risk tolerance/goals, it typically makes sense to have some of their investments spread across company sizes and to make sure a portfolio isn’t just exposed to one section of the market.

  • The columns (from left to right) are Value, Blend and Growth companies. An easy way to think about this is remembering that companies earn money for their shareholders in two ways, either through paying dividends or through growth in the price of their stock. In this fashion, Value stocks are characterized by higher dividends and smaller growth in share price, while growth stocks pay a smaller (or no) dividend and instead, reinvest their earnings back into the company to fuel growth. Knowing these criteria, it is clear how it can be beneficial for an investor to have some exposure to value and growth stocks across small, medium and large companies.

Asset location pertains to where we hold specific types of assets, for example in a Roth IRA, a Traditional 401(k) or a taxable brokerage account. Real Estate Investment Trusts (REITs) and bonds typically pay relatively large dividend and interest payments that are taxed as ordinary income, so it is usually beneficial to the investor to hold these in a tax deferred or tax exempt account. On the other hand, stocks pay a smaller dividend and as long as they are held for a year or more are taxed the lower capital gains rate. No tax is obviously superior to lower capital gains rate tax, so it still makes sense to hold stocks in a tax-free account, like a Roth IRA or Roth 401(k). However, if those same stocks are held in a tax deferred account, such as a Traditional IRA or Traditional 401(k), the capital gains will be taxed at the higher ordinary income rate instead of the lower capital gains rate as if they were simply held in a taxable account. That is why, depending on the situation and if the stock or mutual fund is more growth than value oriented, it may make sense to hold it in a taxable account rather than a tax deferred account.


All of this may sound complicated and it is a bit more of an advanced strategy but we are always happy to walk you through our logic trail and why we locate specific investments in specific accounts. Overall, the goal here is to introduce the topic and get the wheels turning. Keep investing!


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