As readers of these pages send me questions and comments I'll add some of the most interesting ones here. Why not start a discussion? If you have questions or answers, write me!

Q: How do you take into account 401k plans? I understand that you would want to want to come up with an optimal portfolio, but how do you calculate / evaluate the tax savings of maximizing a 401k?

A: I'll tell you what I've done for myself - I do the asset allocation as if I had no limits on my investments. I figure out how much I need in each class to be on the efficient frontier. Then I look at constraints.

A big constraint is my 401K, since it only offers a limited number of investments. For instance, my efficient portfolio may call for 30% in International Equity, yet my 401K doesn't offer an IE investment. If I have more than 70% of my investable assets in my 401K, then even if every dollar outside the 401k is in IE, I won't get to the frontier.

By putting these constraints on your investments you pull down your personal efficient frontier - for any given level of risk you will get less return than an unconstrained portfolio. Good portfolio construction software should let you constrain investments in asset classes and draw your own efficient frontier parallel to the unconstrained one, but closer to the x-axis.

Q: Should I put less money into my 401k so that I can have enough flexibility to construct the most efficient portfolio?

A: I don't think so. Weighing in against the negative of a lower efficient frontier is the tax sheltered status of the 401k. Assume you have $100 of income that could go into a 401k or not. If you put it into a 401k then the full $100 will grow at the rate of return of the investment. If the investment you choose pays dividends or capital gains, those are also tax sheltered. If you don't put the $100 in the 401k then right off the bat you pay the IRS $30 and have only $70 left to invest. In addition, say the non-401k investment you choose pays capital gains of 10% at year end. You have to pay taxes on that as well!

Here's an example:

$100 in an investment paying 10%

in a 401k out of a 401k

yr0 $100 $70

yr1 $110 $75

yr2 $121 $81

yr3 $133 $87

Of course when you take the money out of the 401k, lo those many years from now, you have to pay taxes on it. You hope to be in a lower tax bracket then, but even if not, consider extending the example so that you are 65 in yr4:

$133 $87

tax 30% $ 40 $ 0

net $ 83 $87

Given that the tax rate remained at 30%, in only 4 years the 401k was not as good a deal. Extend the example out 20 years and the 401k is the better deal. But, if your post retirement tax rate was 25% instead of 30%, then it's a wash even at 4 years.

Q: I'm planning to retire before I'm old enough to take the money out of my 401k without a penalty. Should I still put money in my 401k?

A: Sure! First, you'll spend your non-401k
money before you spend your 401k money. Your taxable portfolio might last
until you're old enough to take money out of the 401k without the penalty.
Second, if you retire early and take your money out of the 401k then you
*only* have to pay a 10% penalty in addition to paying taxes on the
money as income. Seems like a lot, but what's 10%? In my thinking it's one
year's return. So, taking the money out is the equivalent of losing one
year's investment return. That doesn't seem like such a big deal. As the
tax laws change there might also be other ways to take the money out of
your 401k with less penalty. Check with a professional!

Q: I'm using software or an advisor that only considers seven asset classes. Is that a problem?

A: I used to think this was a problem. Now I'm not so sure. In recent years a lot of my reading has said that most of the un-correlation can be had with just seven asset classes.

To be properly invested in an asset class you need to buy many securities in that class. (I've been told that you have to buy 100 securities in a class to really represent it well. That seems way too many to me, but that's the story. I use mutual funds and avoid the concern since a typical mutual fund is invested in 100's of securities.)

The real question is what are you missing if you only use 7 classes? Additional asset classes provide more variables to use in the correlation analysis. Hence, the model can construct a "more efficient " frontier. In the same way that avoiding some asset classes will constrain your efficient frontier, more asset classes will free it. Bottom line: with more asset classes to consider you should be able to construct a portfolio with less risk for any given level of return.

In this graph, the seven asset class model is the solid blue line. The 150 asset class model is the dashed black line. Note that for every given rate of return, the more complex model offers a portfolio with less risk. Looking at it another way, these sample models show a 3% return difference for the same level of risk. And this is just an example graph; the real difference might be far less. In fact, many times the seven class model might yield a maximally efficient portfolio.

Q: My advisor offers several portfolios for me to choose from: aggressive, moderate, conservative, moderate - no international, aggressive - high tech focus, etc. She recommends one, but what does it all mean?

A: These words are names the advisor is giving to some pre-constructed portfolios. Your advisor is attempting to simplify the process for you by using words to represent what the portfolio is constructed to do. The aggressive one has a high estimated return and a high standard deviation. Some investors have an emotional response to some investment classes ("I don't want no international" or "Get me into Google"). Your advisor has (I hope) run the model at several different rates of return and with several imposed constraints. Still, each of the portfolios has a target return and computed standard deviation. Ask your advisor to give you the expected rate of return and standard deviation for each of the portfolios. Then you can choose based on these figures instead of her names. If your advisor looks at you like you're crazy and says, "we can't predict rates of return" or "it's aggressive, it will have a higher rate of return than the moderate portfolio" then pick up your stocks and find another advisor. Hopefully your good advisor will smile knowingly and say, "you are asking the right questions."

Q: Any good web sites out there on investing?

A: Ok, this wasn't a question from a reader, I put it in there. Good question, Jim! Here are a couple.