In real estate, the three most important factors are location, location, location. Location is a surprisingly important consideration in investing, too, though I can’t boil it down to an aphorism GSBM.
What I mean by location in this context is Asset Location, or how you should distribute different asset classes across your taxable and retirement investment accounts to minimize the taxes you pay across all your holdings.
Traditionally, asset location has been done by segregating tax-inefficient asset classes (generally those that produce income taxed at ordinary income tax rates, such as REITs and taxable bonds) into retirement accounts, and tax-efficient asset classes (those with lower tax rates) into taxable accounts. This is a pretty simple approach to reducing taxes for most investors and therefore has been widely implemented.
However our analysis, illustrated below, suggests that differentiated asset location leads to higher after-tax returns for investors who hold the majority of their assets in taxable accounts, as many young investors who work in tech do.
Differentiated asset location differs from segregated asset location in that it focuses on calculating allocations that deliver the best after-tax returns for each type of account – be it retirement or taxable. To make decisions about differentiated asset location, we consider the tax characteristics of an asset class, its potential for risk-adjusted return, and the way it balances the risks of the other asset classes in the account. In other words the allocation is not solely based on tax efficiency or inefficiency.
Differentiated asset allocation is also more practical to implement over time, because it is easier for investors to change their allocations in the different types of accounts as their goals for each account change.