The Mental Accounting of Asset Allocation

A reader asks:

I’m a 30 year old living in Brooklyn making $175/year. I’m currently maxing out my 401k, Roth IRA, and have roughly $45k in a taxable brokerage account. Via my company’s ESOP, my company’s stock has become 20% of my brokerage account even after selling a good chunk steadily over the past several years. This year I received an RSU grant that will begin vesting in 2023. It’s considered a stable dividend growth stock, but not one I have an extremely high conviction for long term. My plan is to sell significant portions to tax loss harvest over the next two years and re-allocate those funds into broad market ETFs.

My question is how best to think about asset allocation. When I view my portfolio collectively (401k, Roth, brokerage), I feel I’m well diversified with broad ETFs making up ~80% of my holdings. But when I view my brokerage in isolation, over 50% is allocated to individual stocks. Should I be viewing these buckets (retirement, brokerage) as separate given the relative time horizons, collectively as my overall asset allocation, or a mix of both?

This is an important question because there are plenty of people out there with numerous investment accounts.

In my family we have an IRA for me, one for my wife, my 401k, my wife’s 403b, a 529 account for each of the kids, a brokerage account and a taxable robo-advisor account. It’s a lot.

While it’s tempting to look at the allocation or performance for each of these accounts on their own, the only thing that matters is the portfolio as a whole. Each account can serve a purpose from tax deferral to income to growth to specific goals and everything in between but the individual parts only matter as a collective.

The whole point of putting an asset allocation together in the first place is that you’ll have different parts of your portfolio performing differently at different times during different market or economic environments.

One of the biggest benefits of diversification is that it can allow you to prepare for a wide range of outcomes without having to predict the exact outcomes in advance.

To do this successfully over the long run, you need to size your allocation such that you’ll be willing and able to stick with your holdings at their worst times. The greatest investment strategy in the world is pointless if you put too much of your portfolio into it and bail at the first sign of trouble.

Where those allocations reside matters more from a tax or liquidity perspective than an allocation perspective.

It’s all one portfolio.

However, I do believe there can be some potential benefits to the bucketing approach from a psychological perspective.

The person asking this question is talking about mental accounting. Mental account is the idea that we have a tendency to mentally sort our money into separate buckets when it comes to spending or saving, even if it’s all one big pile of money.

My favorite example of this comes from an interview with Gene Hackman and Dustin Hoffman.1 The two legendary actors actually lived together back in the early days of their careers.

Hackman shares a story about Hoffman’s approach to saving when they were struggling actors:

It was one pile of money but Hoffman was segregating the whole into smaller parts and giving each one of those smaller parts its own job. As long as you can afford to pay for food, I like this idea when it comes to budgeting.

There are some benefits to the bucketing approach for things like budgeting, saving and even spending down your portfolio for retirement.

My savings account is one pool of money but I have different goals within that account. One bucket is for general savings for unexpected expenses while we have another bucket for travel. Occasionally other goals will pop up that get their own label within the account — holiday spending, weddings, big events for the kids, etc.

Using goals in a mental accounting framework can help you save more money because you have something to look forward to.

I also see the benefits of bucketing during retirement in terms of the accounts you want to use for spending, income, emergencies and long-term growth.

One of my favorite retirement bucketing techniques is to think about how much money you have saved in relatively safe assets in terms of years worth of spending. Let’s say you want to spend down 4% of your market value each year and have 40% of your portfolio in relatively safe assets. That would equate to 10 years’ worth of current spending needs.

This type of mental accounting can help retirees in terms of sizing their exposure between risk assets and assets with relatively less risk.

But I don’t think it makes sense to think about the concentration of your brokerage account on its own. Fifty percent in one holding, especially when it’s the company that pays your salary, is a glaring concentration risk.

Twenty percent is still relatively high for my taste but that’s far more diversified, especially when you have a plan to sell down those shares in the coming years.

This is one of the reasons it’s so important to have a comprehensive investment plan in place. A portfolio of investments by itself is not the same thing as a plan.

A plan requires more thought than a mishmash of holdings. If a single holding or fund makes or breaks your portfolio, you’re probably not diversified enough.

And if you’re only looking at the individual performance of the various holdings, strategies, funds and asset classes in your portfolio, you probably don’t have a plan in the first place.

The overall plan is the only thing that matters when it comes to managing risk and expected returns.

I would only use the bucketing approach when it helps you from a psychological perspective.

We discussed this question on the latest edition of Portfolio Rescue:

Taylor Hollis joined me this week to cover questions on trusts, early mortgage payments vs. investing in the stock market, preparing for black swans and when it makes sense to cut back on retirement savings to fund other life goals.

Further Reading:
My Evolution on Asset Allocation

1Somehow this is my second blog post using a Dustin Hoffman story in the past month.

Podcast here: