3 Reasons Your Asset Allocation May Not Be What It Appears

Jason Stipp: I'm Jason Stipp for Morningstar.

Asset allocation is one of the most important decisions you'll make about your portfolio, but even with a carefully crafted asset allocation plan, your actual allocations might not exactly be what they appear to be.

Here to offer some reasons behind that is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: The first reason why your asset allocation might be different than how it looks on paper has to do with an allocation to Uncle Sam that is actually in your portfolio that doesn't show up when you get that pie chart. What do you need to keep in mind about taxes?

Benz: Well, I think you hit it on the head, Jason. It means that if you're looking at your portfolio and assuming that what you see is what you'll get, that's not necessarily the case once tax effects are factored in. So, an example I would give is, assume that you've got a portfolio that consists half of a Roth IRA and half of a traditional IRA. The Roth is maybe all in stocks and the traditional IRA is all in bonds. Well, it looks like 50-50 on the surface, but really that bond piece, because it's going to be taxed upon withdrawal, is actually lighter than 50%.

So, you need to bear that in mind, and the issue becomes of increasing importance as you get closer to retirement--that you need to be thinking more and more about this issue because it's getting closer and closer to the time that you'll actually be taxed upon that money as you make these withdrawals.

So, I'm not saying that you have to just live with that imbalance. You can actually take steps to address it. The key point is to know that these tax effects are real and that they do affect your asset allocation.

Stipp: Another kind of effect, and one that we've written about in our fund research a lot, is the fact that your managers can be doing things behind the scenes, and although you might have a large-growth fund when you look at your whole portfolio, maybe he's decided that he's found some value somewhere else, and the portfolio was changed up a lot. It could also be a big issue if you have these managers that have wide latitudes.

So, how can you account for some of these effects that could really tinker and play around with what your asset allocation targets would be?

Benz: That's exactly right. So, the large-growth fund you mentioned, for example, Jason might have a little bit of cash. It might have some foreign stocks. It might have some small- and mid-cap stocks.

So, it's important to not just take funds on their word, by their labels or whatever, don't assume that what a fund is saying it's doing, is actually what it's doing.

The best tool that I know of for getting to the bottom of your total portfolio's asset allocation is using our Instant X-Ray tool, which actually drills into the holdings and apportions them accordingly within X-ray. So, you can see what your actual asset class exposures are, your actual style exposures, and so forth. It's a really good tool for getting beyond what funds say that they are doing.

Stipp: The last one, Christine, it's kind of a thorny one, but it has to do with where you're getting exposure across the globe. So, let's say, I've got an S&P 500 Index fund, and I feel like I need to go out and also get some exposure to foreign countries. My asset allocation, though, when I look at that S&P 500 is going to say it's all U.S., but that's not really the case.

Benz: That's absolutely not the case. In fact, some of our fund analysts have done some great work in this area, where they've actually looked at where U.S. multinationals are earning their revenues and found out that some of these most seemingly American of companies, companies like Coke and McDonald's, are actually earning a huge share of their revenues overseas. So it's really important to step back and think about how global your portfolio might be even without adding any foreign exposure.

I still think it's important to add foreign exposure, because certainly there are some great companies that just happen to be domiciled overseas. But the average portfolio that's all U.S., maybe an S&P 500 Index fund, for example, is actually quite global in and of itself.

So, I guess the main point I would make here is that it's probably a misspent effort to spend a lot of time looking at your foreign versus U.S. exposure, because these things are really squishy once you get beyond country of domicile.

Stipp: So, trying to gauge it down to the exact percentage point, you're never going to be able to get there, because of all of the international trade and international business that's going on?

Benz: More broadly I would say that this is the case just in terms of your total portfolio's asset allocation. As valuable as asset allocation is--and I do think it's one of the most important determinants of whether your financial plan hits your goal or not--it still is an inexact science. So, getting really hung up on, do I have 52% U.S. or 53% is not going to be a great use of your time.

Stipp: All right, Christine. Thanks for helping us at least stay in some of those broader boundaries and understand some of the swing factors that could make your asset allocation a little bit different than what you would expect. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: I'm Jason Stipp for Morningstar. Thanks for watching.