Individual wealth management

2012 morning exam Q 1 A :the answer given does not make any sense to me:

Tax exempt investors bear all of the risk associated with returns in their accounts. Taxable accounts have the effect of sharing investment risk between the investor and the taxing authority. In negative-return years, losses can offset taxes on other income or gains. In positive-return years, after-tax return is lower than pre-tax return. This smoothing effect of taxes on investment returns (lower returns in positive years and higher returns in negative years) reduces the overall volatility of the return stream and, all else equal, reduces investment risk.

Can anyone explain?


when you are a taxable investor - you pay taxes to the govt. That is on the returns you made on your portfolio. You shared the gains with them (the government) by paying taxes. So your net returns are R*(1-T) where T is your tax rate, and RT is what goes to the Government.

That is the statement: In positive-return years, after-tax return is lower than pre-tax return

In years when you have losses - you can use the losses to offset the other incomes you might have - so you pay lower taxes as a result. This has the effect of smoothing returns - reducing volatilty. – which in turn reduces risk.


If you got all the above …

a tax exempt investor has no such smoothing effect and thus all risk associated with the investment returns belongs only to the investor.