Refining After-Tax Return and Risk Parameters

Abstract

Taxes introduce certain complexities, requiring proper adjustments to return and risk parameters. The author offers a refined set of after-tax return and risk equations for use in practice and validates them with a stochastic future value cash flow model. The refined after-tax return and risk parameters can be used in portfolio optimization, Monte Carlo simulation, and deterministic present/future value portfolio modeling with internally consistent results. The refinements improve the discovery of the optimal after-tax portfolio and enhance long-term wealth planning in the presence of risk.

TOPICS: Wealth management, factor-based models

Key Findings

• • After-tax return and risk parameters are necessary for efficient asset allocation and accurate wealth planning.

• • Parameters must incorporate tax complexity while producing internally consistent results across portfolio optimization, Monte Carlo simulation, and deterministic modeling.

• • Refinements include the arithmetic-geometric return treatment with tax, a more precise incorporation of the effective annual capital gains tax rate, and risk manifesting in the price return across the distribution.