Capital Gains Taxes and Portfolio Rebalancing

The major friction that investors face in rebalancing their portfolios is capital gains taxes, which are triggered by the sale of assets. In this article, we examine the impact of an investor’s capital gains tax liability and existing risk exposure upon the optimal portfolio and rebalancing decisions. We capture the trade-off over the investor’s lifetime between the tax costs and diversification benefits of trading. We find that the investor’s incentive to re-diversify the portfolio declines with the size of the capital gain and the investor’s age. Unlike conventional financial advice, the reset of the capital gains tax bases and the resulting elimination of the capital gains tax liability at death, suggests that the optimal equity proportion of the investor’s portfolio increases as he ages.