From Location to Allocation: Taxable and Tax-Deferred Investing with Portfolio Constraints

38 Pages Posted: 7 May 2004

See all articles by Jennifer C. Huang

Jennifer C. Huang

University of Texas at Austin - Department of Finance

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Date Written: May 2004

Abstract

Academic literature and popular advice in general agree on the fact that investors who have access to both a taxable and a tax-deferred account should follow a "pecking order" location rule of preferring highly taxed assets in a tax-deferred account. There is however little guidance regarding how investors should adjust their overall portfolio allocation for the presence of tax-deferred accounts, especially when they face such frictions as borrowing and short-selling constraints. In this paper we first derive conditions under which the pecking-order location rule holds and then show that, for investors who follow this rule and face portfolio constraints, the optimal allocation in the two-account problem can be obtained by solving for the allocation in each account separately while treating the portfolio holdings in the other account as a "non-tradable" asset. After deriving this result for the case of a riskless bond and a risky stock, we generalize the optimal two-account allocation rules to the case of multiple assets.

Keywords: Portfolio selection, tax-deferred accounts, borrowing and short-selling constraints

JEL Classification: G11

Suggested Citation

Huang, Jennifer Chunyan and Garlappi, Lorenzo, From Location to Allocation: Taxable and Tax-Deferred Investing with Portfolio Constraints (May 2004). Available at SSRN: https://ssrn.com/abstract=540543 or http://dx.doi.org/10.2139/ssrn.540543

Jennifer Chunyan Huang

University of Texas at Austin - Department of Finance ( email )

McCombs School of Business, B6600
Austin, TX 78712
United States
512-232-9375 (Phone)
512-471-5073 (Fax)

Lorenzo Garlappi (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

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