Asset Allocation and Asset Location Decisions Revisited

Abstract

The author applies a mean-variance optimization approach to examine the asset allocation and location decisions made by individuals. The experiment is limited to two assets—stocks and bonds—which are alternatively held through pension or through taxable accounts. They aim to determine the best combination of asset allocation and asset location, effectively asking the question: “to the degree possible should stocks or bonds be located in the tax-sheltered pension account?” The author considers three types of investors: a trader (who realizes all capital gains within a year), an active investor (who realizes all gains each year but pays preferential tax rates), and a passive investor. He finds that, for traders, there is always more than one optimal portfolio, and there is no optimal asset location: Identical portfolio risk and portfolio return can be obtained with different combinations of asset allocation and asset location. For active and passive investors, the optimal portfolio locates, to the degree possible, stocks in taxable accounts. The analysis offers several investment implications. For example, when someone makes the asset-location decision first, the conditional optimal asset mix calls for a relatively large exposure to the asset held in taxable accounts; thus the optimal stock weight is larger when stocks are held in taxable accounts than when they are held in pensions.