Heuristic Portfolio Trading Rules with Capital Gain Taxes

33 Pages Posted: 7 Nov 2012 Last revised: 7 Apr 2016

See all articles by Marcel Fischer

Marcel Fischer

Copenhagen Business School

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Date Written: December 23, 2014


We study the out-of-sample performance of portfolio trading strategies when an investor faces capital gain taxation and proportional transaction costs. Under no capital gain taxation and no transaction costs, we show that, consistent with DeMiguel, Garlappi, and Uppal (2009), a simple 1/N trading strategy is not dominated out-of-sample by a variety of optimizing trading strategies, except the parametric portfolios of Brandt, Santa-Clara, and Valkanov (2009). With dividend and realization-based capital gain taxes, the welfare costs of the taxes are large with the cost being as large as 30% of wealth in some cases. Overlaying simple tax trading heuristics on these trading strategies improves out-of-sample performance. In particular, the 1/N trading strategy's welfare gains improve when a variety of tax trading heuristics are also imposed. For medium to large transaction costs, no trading strategy can outperform a 1/N trading strategy augmented with a tax heuristic, not even the most tax- and transaction-cost efficient buy-and-hold strategy. Overall, the best strategy is 1/N augmented with a heuristic that allows for a fixed deviation in absolute portfolio weights. Our results show that the best trading strategies trade diversification considerations off against tax considerations without solely focusing on one or the other.

Keywords: portfolio choice, capital gain taxation, limited use of capital losses, heuristic trading rules

JEL Classification: G11, H20

Suggested Citation

Fischer, Marcel and Gallmeyer, Michael F., Heuristic Portfolio Trading Rules with Capital Gain Taxes (December 23, 2014). Journal of Financial Economics 119(3), 611-625, 2016. Available at SSRN: https://ssrn.com/abstract=2172396 or http://dx.doi.org/10.2139/ssrn.2172396

Marcel Fischer (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
+45-3815-3628 (Phone)

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

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