How do taxes effect the risk-adjusted return of equities?

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AviN
Posts: 475
Joined: Mon Mar 10, 2014 8:14 am

How do taxes effect the risk-adjusted return of equities?

Post by AviN » Sat Jan 03, 2015 11:07 am

I've been thinking about the effect of taxes on the risk-adjusted return of equities a taxable account.

On one hand, equities have a positive expected return and federal capital gains and dividends taxes are expected to lower that return.

On the other hand, the expected returns of equities have high standard deviation. For an investor that tax-loss harvests, federal capital gain taxes have the effect of reducing standard deviation both on the upside and downside. Basically, the IRS reduces standard deviation by sharing in both gains and losses. Though one consideration here is that (at least the way I understand it) the IRS shares in losses only if the price falls below the cost basis, a situation that decreases in probability the longer the equities are held.

So I'm wondering how the combined effect of these two factors affect risk-adjusted return metrics like Sharpe ratio, and how federal taxes compare to other conventional means of reducing downside standard deviation like holding bonds and cash. My intuition suggests that federal taxes should substantially lower Sharpe ratio and serve as an inefficient way to reduce downside standard deviation, but I'm not so sure.

There's also the issue of state capital gains and dividends taxes. At least in my state (NJ), losses can't be deducted or carried so it seems there would be no benefit in terms of reducing downside standard deviation.

Does anyone have any thoughts or references to research on this?

Avi

JimInIllinois
Posts: 345
Joined: Wed Dec 22, 2010 9:55 am

Re: How do taxes effect the risk-adjusted return of equities

Post by JimInIllinois » Sat Jan 03, 2015 11:29 am

I have considered the idea that the riskiest assets should be held in tax-deferred accounts because the uncertain return of those assets will be somewhat damped by progressive taxation on withdrawal. If stocks do well you shouldn't mind paying a higher tax rate but if they do poorly your marginal rate may be lower than when you were saving. Conversely, the safest assets like bonds belong in Roth accounts since you are fully exposed to fluctuations. These choices would result in higher taxes if stocks do well, but I would take the risk of higher taxes on my wealthy future self in exchange for lower taxes on my poor future self.

My assets are not currently arranged this way because of certain types of funds aren't available in the desired account, but it has made me less interested in Roth accounts in general.

A counter-argument would be that over long periods of time stocks are almost certain to outperform bonds.

JimInIllinois
Posts: 345
Joined: Wed Dec 22, 2010 9:55 am

Re: How do taxes effect the risk-adjusted return of equities

Post by JimInIllinois » Sat Jan 03, 2015 11:36 am

https://www.bogleheads.org/wiki/Tax-adj ... allocation discusses some of what you are asking, but if your returns don't effect your tax rate then it is like the government owns a fraction of your account equal to your marginal tax rate. Since this reduces risk and return by the same factor the Sharpe ratio doesn't change.

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