BFS 2002

Contributed Talk

We study the consumption-portfolio problem of an investor who has access to multiple risky stocks and faces capital gain taxes. The optimal investment strategy depends on the correlation between the stocks as well as whether the investor is allowed to sell short or use derivatives. With multiple stocks that are highly correlated we find instances when the investor optimally holds an undiversified equity portfolio. When short selling is allowed, the investor shorts stocks for two reasons: to imprerfectly short the box ex-post in order to reduce aggregate equity exposure; and ex-ante to minimize future tax-induced trading costs. We term this second strategy a trading flexibility option. A similar trading flexibility option is implicitly present if the investor can not short but is allowed to buy put options. We find that, somewhat surprisingly, for investors who are prohibited from shorting, the benefit of trading separately in the two stocks is not economically significant, while, on the other hand, the welfare benefit is significant for investors who can short at a low cost and for those who can trade in derivatives.       http://www.bus.utexas.edu/faculty/stathis.tompaidis/research/taxes/main.pdf