Tax Aware

When Fortune Doesn’t Favor the Bold: Perils of Volatility for Wealth Growth and Preservation

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When Fortune Doesn’t Favor the Bold: Perils of Volatility for Wealth Growth and Preservation

Successful entrepreneurs and executives often hold much of their wealth in a highly appreciated single stock and thereby face a difficult financial dilemma. On the one hand, the high idiosyncratic volatility of a concentrated single stock position can lead to significant risk of catastrophic losses; on the other hand, selling the stock can result in an immediate and punitive tax burden. 

This paper develops an analytical framework for evaluating this choice and explains how it relates to classic betting strategies and economic theory. Calculations suggest that for many investors a full and immediate liquidation of their appreciated single stock might be optimal from the perspective of long-run wealth growth and preservation. In fact, the findings demonstrate that in absence of diversification most investors must expect catastrophic losses of wealth over reasonable investment horizons. 

For investors reluctant to incur an upfront tax burden, tax-efficient techniques for disposing of appreciated single stock might strike the balance between the urgency to diversify concentrated risk and aversion to taxes. Whereas for median and mode cumulative wealth the primary effect likely comes from diversification, be it tax-efficient or not, for mean cumulative wealth tax efficiency of diversification can yield a tangible improvement.

 

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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. The hypothetical performance shown was derived from the retroactive application of a model developed with the benefit of hindsight.  Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.

 

AQR Capital Management is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views expressed here are those of the authors and not necessarily those of AQR.