As supported by decades of research, diversification brings many meaningful benefits to a portfolio. They include: 1) providing reliable exposure to market returns, 2) allowing investors to emphasize stocks with higher expected returns, 3) improving the reliability of capturing equity premiums, and 4) enhancing robust portfolio implementation.
However, in some situations, investors may have their wealth concentrated in relatively few holdings. Should holders of such portfolios sell concentrated positions, potentially incurring capital gains taxes, in order to pursue a well-diversified investment strategy?
In our new paper “SMAs: Quantifying the Tradeoffs Between Taxes and Diversification,” we consider the tradeoffs associated with such transitions and show that, in many cases, a broadly diversified portfolio can lead to an increase in expected wealth over the long term compared to a concentrated portfolio, net of taxes incurred during the transition.1
Suppose an investor holds a $1.5 million portfolio consisting of five stocks, with unrealized gains accounting for one-third of the portfolio value. This investor is faced with a decision: hold on to the concentrated portfolio or liquidate it in favor a broadly diversified solution, incurring capital gains in the transition. We examine the outcome if this investor maintains the same concentrated portfolio or transitions to a well-diversified portfolio.
We consider two broadly diversified alternative portfolios: The first, Transition A, maintains the same expected return as the existing portfolio, just with more holdings; the second, Transition B, represents a portfolio that also has a systematic emphasis on stocks with higher expected returns and therefore a slightly higher expected return.
Informed by historical performance, we assume the following:
- The existing portfolio and Transition A have an annualized expected return of 9%, while Transition B has an expected return of 10%.2
- The annual volatility of the concentrated portfolio is 30% and the volatility of the well-diversified transition portfolios is 20%, based on the standard deviation of simulated portfolios with varying levels of diversification.3
- The capital gains tax rate is 25%, and the cost basis of the $1.5 million existing portfolio is $1 million.
- Portfolio returns follow a lognormal distribution given the parameters set forth above.
Based on these assumptions, we derive a distribution of outcomes over the subsequent 25 years and also examine several alternative scenarios by increasing the tax rate, lowering the cost basis, and varying volatility parameters, for example.
In all scenarios, the final values of both diversified portfolios exceed that of a highly concentrated portfolio. Compared to the existing portfolio, Transition A has lower volatility, which improves compound returns over time. Transition B, with a higher expected return due to its systematic and efficient pursuit of equity premiums, further improves the investment outcome over the long run. That is, across different portfolio and tax assumptions, an investor can expect to have higher wealth in the long term, despite incurring capital gains today, by holding a well-diversified portfolio that efficiently pursues even moderately higher expected returns.
For brevity, we focus on the base case, as described above, and plot the growth of wealth at the 25th, 50th, and 75th percentiles over 25 years in each portfolio in Exhibit 1.
After just one year, the 50th percentile outcome for Transition B exceeds the 50th percentile outcome for the existing portfolio. At the 10-year mark, Transition A and Transition B grow to a respective $2.4 million and $2.6 million at the 50th percentile, compared to $2.1 million for the existing portfolio. The benefits of broad diversification and a systematic pursuit of premiums continue to accrue over time: After 25 years, the median wealth for Transition B is $7.8 million, followed by $6.2 million for Transition A, both meaningfully higher than $4.1 million for the existing portfolio. In addition, Transition B has higher ending wealth at the 25th, 50th, and 75th percentile outcomes than Transition A, which in turn has higher ending wealth at each of those percentiles than the existing portfolio.
Incurring taxes on capital gains is a tangible cost in transitioning to a well-diversified portfolio. However, our analysis suggests that the less tangible costs of not transitioning, in terms of what an investor may be giving up in the future, may be greater.
There may be situations that compel investors to postpone the liquidation of a concentrated position. We can plan for such situations by designing investment solutions that provide alternatives to immediate liquidation to help clients meet their investment goals. For example, efficient incorporation of charitable gifting that focuses on positions with a low cost basis can help investors reposition concentrated holdings without adding to their tax bill.
In times of frequently changing tax rules, holding a well-diversified portfolio is one important tool available to investors to manage uncertainty and help them achieve their investment goals.