Academy of Financial Services Annual Meeting 2022

Diversification return; Capital gains; Risk

Investors with taxable portfolios sometimes delay the sale of appreciated stock to defer capital gains taxes. While this strategy may reduce taxes, it can cause the portfolio to become more concentrated over time, leading to higher overall volatility and lower long-term returns. We evaluate the tradeoff between tax efficiency and diversification via Monte Carlo simulation and find that the latter has a far greater impact on the investor’s terminal wealth, especially over longer time horizons. For the scenarios considered, the investor is better off rebalancing almost completely each year, even though it requires selling some recent winners and paying capital gains taxes.