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Press Release

Michael B. Laffin

For immediate release:
August 9, 2004

Investors May Sacrifice Significant Portfolio Returns by Ignoring Tax Implications of Asset Allocation and Location

PITTSBURGH—Investors risk sacrificing as much as 15 percent of portfolio value by failing to consider the tax implications of where assets are held, according to a study in a recent issue of the Journal of Finance. The research demonstrates the wisdom of an allocation/location strategy that evaluates how the opportunity to invest through both taxable and tax-deferred accounts affects optimal portfolio decisions over an investor's lifetime. Specifically, the study examines how much of an asset to hold (asset allocation) and which assets to hold in taxable accounts or tax-deferred accounts (asset location).

In "Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing," Robert Dammon, professor of financial economics, and Chester Spatt, Mellon Bank Professor of Finance and director, Center for Financial Markets, from the Tepper School of Business at Carnegie Mellon University, present compelling advice on ways to maximize long-term returns through a combination of tax sheltering and thoughtful portfolio allocation. The study, which appeared in the journal's June issue, was co-authored by Harold Zhang, associate professor of finance at Kenan-Flagler Business School at the University of North Carolina.

Their findings contradict common investment practices. According to the authors, many financial planners and self-directed investors routinely fail to consider the split of wealth between taxable and tax-deferred accounts at the time they determine their overall asset mix.

"Most investment planners want to determine the optimal mix of assets before they determine their location, when in fact these two decisions should be made simultaneously," Dammon noted. "Further, financial advisors commonly recommend a mix of stocks and bonds in both the taxable and tax-deferred accounts, with some advising investors to tilt their tax-deferred holdings toward equity. We found that the cost of this practice can be quite high, especially for younger investors."

In fact, approximately half of U.S. investors who hold taxable bonds in taxable accounts also hold equities in their tax-deferred retirement accounts.

"With self-directed investing continuing to increase due to the decline of defined benefit programs, people routinely face the issue of how to invest taxable and tax-deferred assets," said Spatt. "As a person ages and reaches retirement, the issue becomes one of allocating exposure.

"There are distinct advantages to placing exposure where you derive the greatest tax benefit, but people often don't do this," Spatt added. "Investors can gain considerably by shifting the location of their assets to conform with the more tax-efficient policies that we address."

The study focused on allocation and location decisions for investors who had the opportunity to invest in a taxable one-period bond and a risky stock index. Additionally, the investors could contribute a fraction of their labor income to a tax-deferred (retirement) account. The investor's age, existing portfolio holdings, capital gains and available wealth levels in both kinds of accounts were considered.

Ability to Borrow Is Key

The findings indicated that when investors have the ability to borrow to meet financial obligations, the best portfolio mix is a tax-deferred account invested entirely in taxable bonds, paired with a taxable account that is invested in equity and either a long or short position in bonds. If borrowing to meet spending needs is impossible, the best approach is to hold a mix of stocks and bonds in the tax-deferred account but only if the investor's taxable account is allocated entirely to equity.

Several additional factors determine the ideal split between equities and bonds, including future liquidity needs. For example, if an investor will need a down payment on a house, she may find it more lucrative to hold some bonds in taxable accounts to reduce the risk of a funding shortfall. "However, we found that for most investors the benefit of holding bonds in the taxable account for liquidity reasons is small relative to the tax cost," said Dammon.

This current study builds onto a body of research that Dammon, Spatt and Zhang have conducted on similar investment models with unique variables.


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