We’re back to work on our investor knowledge series here in the Briefing Room, the kids are headed back to school, and if you’re in the military, PCS “season” is drawing to a close.  We’ve entered into a seasonally weak period of the market and recent tensions in the Pacific theater haven’t helped the situation.  Looking back to 1970 in the monthly returns of the S&P 500 index, August has had a mean return of -0.09% and September has been the worst performer during the year with a mean return of -0.78%.

And if you’re wondering how a strategy of exiting the market completely during August and September would’ve performed over the same period, then here’s you answer (warning:  don’t get excited… see below):

(Source:  Targeted Wealth Solutions internal research)

This is an illustrative point only… and the devil’s in the details.  We won’t get into the weeds with the properties of the strategy, but here’s the real reason this is a fool’s errand:


If we assume you traded this strategy in a standard (taxable) brokerage account, your life would be one of short term gains and the resulting tax bill.

Which brings us to our topic of “location” when it comes to assets.  That’s right, asset location… not asset allocation, but where you place your investments rather than what your investments are.

(Targeted Wealth Solutions)

Viewing your investment accounts as interconnected

You’ve probably heard about the benefits of diversification and probably even have nicely diversified taxable accounts and retirement accounts.  But the premise of asset location rests on the fact that some assets are more tax efficient than others and therefore should be placed in accounts without favorable tax treatment.  For instance, your favorite actively managed mutual fund or ETF may distribute capital gains that are taxable at a higher rate than qualified dividends.   Additionally, certain asset classes have higher expected returns that may result in a higher gain that will be subject to taxation at some point down the road.

With that said, it’s important to look at all of your long term investment accounts from a holistic perspective; that is, everything is working together to help you reach your goals and objectives.  Most folks look at each account as an independent portfolio, but asset location challenges that perspective by encouraging investors to diversify across accounts with respect to tax treatment. 

As an example, high expected return investments that are tax efficient (you can research tax efficiency at sites like Morningstar) should be placed in a taxable account.  Example investments include domestic and developed international growth stocks (passively managed or indexed).  Tax inefficient investments like commodities, active strategies, high yield debt, and emerging market stocks should be placed in tax exempt or tax deferred accounts.

The first step is then to rank your investments based on return expectancy (highest to lowest) and then by tax efficiency (highest to lowest).  From there, you have a starting point to build out your household portfolio’s asset location plan.  And yes, this may mean having only bonds in a tax deferred/exempt account!  You may look at that and say, “where’s the diversification?”  The balance is achieved by having your equity exposure in another account, so that your household investments — when viewed in aggregate — are diversified.  Your risk tolerance and time horizon may create a different resulting mix of investments, but the premise holds: utilize the tax benefits of retirement accounts to hold tax inefficient investments.

The “it depends” scenarios

Trusts introduce a slight wrinkle into the mix.  Depending on whether the trust is revocable (taxed on your personal tax return) or irrevocable (taxed as a distinct and separate entity), the investments will differ.  Income producing assets are a chief concern here for irrevocable trusts since the tax brackets are close together.

Additionally, if you are investing for short term goals or needs, tax efficiency takes a back seat to a diversified portfolio that’s tailored to your risk appetite and time horizon. 

So what does this buy me?

Like we mentioned in a previous post about the value of a financial advisor, the value of asset location could be the equivalent of an additional .75% return each year.  Michael Kitces, a highly regarded financial researcher and educator, thinks the average number is .25%.

No matter what number you go with, that’s additional equivalent return that you could achieve just by looking at your investments as a whole and taking advantage of deliberate placement of certain assets in certain accounts.

That’s a pretty good deal courtesy of our current tax code.

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