Sharpe, Markowitz & Capital Gains Taxes

 "There are no unintended consequences. Only unwanted consequences." 
The Quotations of Slim Fairview


Forty years ago, I learned about the Sharpe-Markowitz Efficiency Curve.  The theory explained the risk-reward ratio for investors.  I will now Illustrate what that means and apply it to capital gains taxes.


To begin:  The higher the risk, the higher the reward.  The lower the risk, the lower the reward.


Hence:

Option One: You put your money in the Hellmann's Backyard Mayonnaise Jar Bury & Trust*.

You have little if any risk exposure to market fluctuations or Corporate incompetence.  However, you make no actual return on your money.  Your money will, however, lose value based on inflation.

Option Two:  You go to Roosevelt Raceway where you place your best on Fast Money going off at 50 to 1. 

There is a third option.

Sure Thing.  Sure Thing is going off at 2-1/2 to 1.

There is little if any chance of Fast Money winning the race.  However, if he does, you collect $100. 

Sure Thing will probably win the race.  However, if he wins, you collect $5.

Now, to analyse the investment strategy:

You won't risk $1000. on Fast Money because he is unlikely to win.
You might risk $1000. on Sure Thing because you must minimise your risk and weigh risk against return in your portfolio diversification.

Here is the analogy to real life.

For the purposes of illustration only: 

You earn a Million Dollars a year.  I earn $100,000 a year.

You invest $100,000. in the market each year.  I invest $10,000 in the market each year.

Let's go back to Fast Money & Sure Thing.  

A $2. bet on Fast Money will pay $100. minus the 20% tax.  I collect $80.  (Okay, a risky bet, however, it was a long shot and it was only two dollars.)  However, If I tell you about my bet, and you tell 10 people and they tell 10 people, then the payout will drop considerably.  Now I am betting $2. on a long-shot that will pay only $5. ($4. after taxes.) Not an acceptable investment.

You don't mind the $2. bet on Fast Money (speculation), however, you prefer investing in Sure Thing.  Still, a $2. bet will get you back only $5.  Or, after taxes, $4.  However, if you tell 10 people and they tell 10 people, your payout will drop to even money.  Not a good risk-return investment at all.  However, as you are a professional investor, you invest larger sums.


Now, to the "Stock Market".

You must increase your investment in Sure Thing.  You invest $2000. in Sure Thing.  The return is $5000.  Or, after taxes, $4000.  Still, there is a bit of a risk, a calculated risk, but a risk none-the-less.

Now taxes go up to 30%.

My $2. on Fast Money will return $100. minus 30% in taxes, or $70. Not bad for a $2. fun bet if I don't tell anyone about it.  However, this is not an investment strategy.

Your $2000. investment in Sure Thing will return $5000. minus 30% or $3,500.  The risk return ratio is moving out of favour. You must realign your portfolio.

Back to the Millionaires. 

With my [theoretical] $100,000 income (and increasing capital gains taxes)  I cut back my investments from $10,000. a year to $5,000. a year.  I am investing more cautiously:  

I invest in Gold Coins and the Hellmann's Backyard Mayonnaise Jar Bury & Trust.


You, however, with your Million Dollar a year income, cut your investments back from $100,000. to $60,000.  You are apprehensive about the diminished return on your exposure as a result of the capital gains tax increase.


Now, we have a friend who earns $10 Million a year.  He invests Two Million Dollars a year.  He can better afford the risk.  With 2 Million Dollars invested, Sure Thing will pay our friend $5 Million in return minus 30% in taxes, or a $3,500,000. return on his investment.  Our buddy can better absorb the risk.


What does an increase in the Capital Gains Tax cause?

Small Investor Presence will diminish considerably.


Big Investor Presence will diminish some.


Biggest Investor Presence will increase.


The old saying, 

"The rich get richer...."  Will be replaced.  

The new saying will be 

"The Richest Get Richer...."


There are no unintended consequences.  Only unwanted consequences.  (Depending on who you are.)


Warmest regards, 


Slim

* Hellmann's® and Best Foods® are registered trademarks. Best Foods® is known as Hellmann's® east of the Rockies.

Disclosure: The reference to Hellmann's was an unsolicited reference for which this blogger received no compensation. This blogger enjoys using Hellmann's Mayonnaise.


slimfairview@yahoo.com


Copyright (c) 2012 Slim Fairview
All rights reserved.