Individual Responses to Realized Gains and Losses

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Individual Responses to Realized Gains and Losses

Post by Beliavsky » Mon Feb 11, 2019 6:58 am

I think investors should not let their asset allocations change in response to fund closures.

Fully Closed: Individual Responses to Realized Gains and Losses
Steffen Meyer and Michaela Pagel
NBER Working Paper
February 2019
We use transaction-level data of portfolio trades and holdings linked to checking, savings, and settlement account transactions and balances to explore how individuals respond to realized capital gains and losses. We exploit plausibly exogenous sales due to mutual fund liquidations for identification. Specifically, we estimate the marginal propensity to reinvest out of one dollar received from a forced liquidation, when the investor either achieved a gain or a loss relative to his or her initial investment. Theoretically, if individuals held optimized portfolios, the marginal propensity to reinvest out of forced sales should be 100%. Individuals should just reinvest all of their liquidity immediately into a fund with similar characteristics. Empirically, individuals reinvest 83% on average if the forced sale resulted in a gain, but only 40% in the event of a loss. If individuals do not reinvest, they keep a share of their newly found liquidity in cash, save it, or consume it! . Such differential treatment of gains and losses is inconsistent with active rebalancing or tax considerations, but consistent with mental accounting and the idea that individuals treat realized losses differently than paper losses. We thus provide evidence for realization utility and effects (Barberis and Xiong, 2012; Imas, 2016) and that individuals do not appear to learn rationally from experiences in the stock market (Malmendier and Nagel, 2011; Koudijs and Voth, 2016).

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Re: Individual Responses to Realized Gains and Losses

Post by UpperNwGuy » Mon Feb 11, 2019 7:02 am

Could someone translate the above paragraph into modern American English please?

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Re: Individual Responses to Realized Gains and Losses

Post by livesoft » Mon Feb 11, 2019 7:42 am

It means that if one sells for a loss, then one should buy replacement shares and not just spend the cash.

I skimmed the paper, HOWEVER, if people need to raise cash to pay for something, then the most tax-efficient way is likely to be sell the losing position, then make adjustments in another account (a tax-advantaged account) to restore asset allocation.

Example: I need money to buy a car. I sell $20,000 of equity shares that have a $10,000 loss in my taxable account, then I exchange from a bond fund into an equity fund in my IRA in order to restore my asset allocation back to equities.

Example: To tax loss harvest, sell a loser, but don't put the money in cash, instead buy something similar, but not substantially identical, to what was sold.

The data set used in the working paper was from Germany where some of the tax laws are different from what I am familiar with. But I think my examples still hold. I think the paper does catch mental accounting, but it may be exaggerated because the authors don't see all portfolio transactions, but only see account transactions (I think).

The article seems to ignore the possible tax advantages for the behavior of investors.
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