Should Investors Defer Long-Term Gains in Taxable Stock Portfolios?

Abstract

Investors with taxable portfolios sometimes delay the sale of appreciated stock to defer capital gains taxes. While this strategy does help to reduce taxes, it can cause the portfolio to become more concentrated over time, leading to higher overall volatility and lower long-term returns. This paper evaluates the tradeoff between tax efficiency and diversification via Monte Carlo simulation and finds that diversification is far more important for the investor’s terminal wealth, especially over longer time horizons. Under a reasonable set of assumptions, investors are better off rebalancing almost completely each year, even though it requires selling some recent winners and paying capital gains taxes. While tax efficiency does become somewhat more important for individuals who are taxed more heavily on gains or who expect an eventual step-up in basis, even these investors should tolerate only a modest increase in portfolio concentration.