While 2014 was the year of real estate for me, 2015 is all about organizing and optimizing our investments. Heres the process we went through so far to optimize our investment portfolio:

1. Setting Goals

Before doing anything else, we had to figure out our financial goals and understand the time horizon for each. Outlining when and what we wanted to use our money for would have a huge impact on the rest of our financial plan.

Given that we wont be buying a car in the next 5 years and we just bought an apartment. we determined that all of our money was essentially for long-term purposes (i.e. retirement).

2. Determining Asset Allocation

Once we agreed on what our short, medium, and long-term goals were, we were ready to figure out what vehicles to use to grow our investments. Typically, this may get a little more complex if we had short and medium-term goals because each bucket of money may require a different asset allocation. Since we only have long-term goals, we can think about all of our investments across accounts as one big bucket.

In terms of asset allocation, based on my research, there is no one-size-fits-all answer as to what your mix of stocks, bonds, and alternatives should be. Stocks have generally yielded more than bonds over a long period of time, but stocks have also been more volatile. The two factors that anyone should take into consideration when determining the right allocation are your investment time horizon (based on your goals) and your risk tolerance (typically gauged by seeing how sensitive you are to negative changes in your portfolio).

Given our long-term time horizon, we decided were comfortable putting the majority of our money in equities. We should be able to weather the large swings that come with a heavily-weighted stock portfolio since we wont need the funds for some time (hopefully).

3. Identifying Optimal Asset Location

After defining our target asset allocation, the next question was, where exactly should the assets sit across our pre-tax 401(k)s, Roth IRAs, and taxable accounts? The easiest technique, which is what I was doing before, would be to have the same asset allocation for each account. Thats definitely not optimal from an expense or tax perspective and heres why:

Expenses

As an example, Vanguards S&P 500 index fund has a couple of different types of share classes: Investor or Admiral shares. Investor shares are for balances between $3,000-$9,999 and Admiral shares are for balances $10,000+.

The key difference between these two share classes for the S&P 500 index fund is the expense ratio. Investor shares have an expense ratio of 0.17% while Admiral shares have an expense ratio of just 0.05% . On a $100k investment, that difference of 0.12% in fees is $120/year. That may not sound like much, but that becomes $600/year for a $500k portfolio or $1,200/year for a $1MM portfolio. That savings alone could pay for your toilet paper needs every year (probably). Overall, Vanguard says Admiral shares are typically more than 20% lower than standard Investor class shares . If youre not invested with Vanguard, you can still take a look at how other investment companies may differentiate on fees between various share classes.

The bottom line is, if you have the same asset allocation across your accounts, you may be unnecessarily paying for the more expensive Investor shares across all your accounts rather than paying the much cheaper Admiral share fees I know I was.

And in the end, fees can take a big chunk out of your return just look at the difference in fee levels below for a pretty typical set of investment options.

Taxes

From a tax perspective, having the same asset allocation across each account is not so optimal either. There are some assets, like REITs and actively managed funds, that are inherently tax-inefficient. That is, they either throw off a lot of income each year to you or they buy and sell their fund holdings often. If these tax-inefficient investments are in your taxable account, they may cause you to realize significant earnings at your ordinary income tax level (for short-term capital gains) instead of the more efficient long-term capital gains rate.

There are other assets, like stock index funds, that may throw off dividends each year, but most of those will be qualified dividends, which are taxed at the long-term capital gains level (15-20%). In addition, only when you sell the stock index fund do you get taxed, and if you hold it longer than a year, any gains would be taxed at the long-term capital gains rate as well.

Because of these nuances, being deliberate about where you put certain assets is extremely important and could have a significant impact on your overall rate of return.

Source: Bogleheads

Taking both of these key factors into consideration when we moved funds around and determined the optimal asset location, we were able to get our weighted average expense ratio down to 0.08%/year . In addition, any extremely tax-inefficient investments are now shielded from taxes in our Roth IRAs, while other more tax-efficient investments are in our pre-tax 401(k)s or taxable accounts. What that means is we dont have to worry about getting a huge 1099-R every year from Vanguard having us pay taxes that ultimately lower our rate of return.

4. Rebalancing

After doing all that fun stuff with respect to asset allocation and asset location. it was time to actually move around our funds according to our plan. Since asset prices are always changing, we know that right after we so precisely allocate our investments, our asset allocation would be off ever so slightly.

Rebalancing our portfolio periodically allows us to get our portfolio back to our target allocation by selling holdings that appreciated, at high prices, while buying other holdings that decreased in value, at low prices. The important question is, how often should we rebalance? Some people do it based on time, such as rebalancing every 6 months or every year. Others do it based on market movements. For example, if your investments are more than 5% off from their targets, then rebalance. I havent quite decided how often well rebalance, but Im leaning toward doing a combination of the time-based approach and the value-based approach.

For a more detailed explanation of rebalancing and its benefits, see this helpful article .

In a nutshell, thats how were optimizing our investments. It sounds easy enough, but a lot of thought, research, and deliberation went into making these final decisions.

Do you need help optimizing your investments? If so, check out some of my services and reach out to me at roger@lifelaidout.com to discuss further.

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