Asset location and allocation with multiple risky assets

Ashraf Al Zaman, Purdue University


Most working adults have access to a taxable brokerage account (TBA) and a tax deferred retirement account (TDRA). According to the existing literature, taxable bonds should be located in the TDRA, while equities should be located in the TBA due to the tax treatments of these accounts. If borrowing is not allowed mixed holdings can be optimal in either account but not in both simultaneously. But if borrowing is allowed all the wealth in the TDRA should be allocated to bonds. Unfortunately, the empirical findings are at odds with the theoretical predictions as investors do hold both equities and bonds in both of the accounts. This discrepancy is known as the asset location puzzle. In this paper, we revisit the asset location issue by extending the model to include multiple risky assets. This allows us to capture the interaction of portfolio diversification and the tax timing option, features that are not captured in the existing models. We find that the correlation structure of the risky assets and the borrowing constraints have substantial impact on asset location decisions. We also find that asset location and allocation decisions are sensitive to the Sharpe ratios of the risky assets and the size of the retirement account. Consistent with the existing empirical findings, we also observe a mix of bonds and equities in either of the account with borrowing constraints and with reasonable relaxation of the borrowing constraints. Furthermore, we document the impact of borrowing constraints, and show that the assumption of unlimited borrowing is not innocuous. Failing to incorporate institutional restrictions on borrowing contributes to the theoretical inconsistencies. To support some of our conclusions, we also provide some empirical evidence.




McConnell, Purdue University.

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