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Two Ingredients for Successful Investing - Pinnacle Investment Management, Inc.

Two Ingredients for Successful Investing

June 2, 2017 / Article, Investments

Asset Location and Rebalancing

In my last article I discussed the importance of establishing a target asset allocation as well as the benefits of diversifying your investments. I consider these the first two steps toward successful investing.  In this article I will address the next two important steps:   asset location and rebalancing.

Asset Location

Once you have established a target asset allocation, your next goal should be to achieve that allocation while minimizing your taxes.   You can accomplish this by placing the most “tax friendly” investments (such as stocks) in taxable accounts and the least “tax friendly” investments (such as corporate bonds) in tax deferred accounts.   By “tax friendly” I simply mean that capital gains on stocks are taxed at a more favorable capital gain tax rate.  There is no tax benefit for realizing capital gains in tax deferred accounts since they will ultimately be taxed at higher ordinary income tax rates when they are withdrawn.  Investments with the potential to have the largest returns such as small company stocks should be placed in your Roth account where they will never be taxed.


Over time some asset classes will advance or decline more than others, resulting in the actual allocations differing from the original target. Rebalancing is the practice of periodically moving the portfolio allocation back toward the target allocation by selling investments in one asset class and buying investments in another.   For example, if your target allocation is 40% fixed income and 60% equities, but as the result of a strong stock market, the allocation to equities might have grown to 70%, with the remaining 30% in fixed income.  To bring the allocation back toward 40% / 60% you would need to sell equities and buy fixed income.  Selling winners and buying losers does not always come naturally to many people, but this discipline does pay off because it results in buying low and selling high.  Studies have shown that rebalancing can add anywhere from 0.5% to 1.0% to the portfolio return per year.

Rebalancing is best done on an asset class rather than an individual security level. The benefits are achieved over one or two market cycles.  Rather than rebalancing on a set schedule, the best results are achieved by looking frequently and rebalancing when asset classes are beyond pre-established tolerance bands such as plus or minus 20% of the target.  For example, if the targeted allocation is 40% to equites, then rebalance when the actual allocation falls to less than 32%  (80% of 40%) or above 48% (120% of 40%).

When asset location and rebalancing are practiced together it is reasonable to expect more than a 1% increase in annual after-tax returns. This may not sound as exciting as finding the next hot stock like Google or Apple, but it is easier to do.  When compounded, an extra 1% per year can result in an extra 17% addition to your principal over ten years.

As in other aspects of life, little things can make a big difference.


About the author

John Eckel: CFP®, CFA is President of Pinnacle Investment Management Inc. of Simsbury. He has been included in BusinessWeek.com’s list of the Most Experienced Independent Financial Advisors, has been named four times to Worth Magazine’s list of Top Financial Advisors, included twice in Medical Economics list of Top Financial Advisors for Doctors and named twice in JK Lasers list of Top Professional Advisors for Baby Boomers.

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