I hope I don't die in a mysterious accident for revealing this secret -- but I'm convinced that Harry Markowitz, whose work forms the foundation for Modern Portfolio Theory, was an undercover agent of the IRS.
Markowitz published the widely influential paper "Portfolio Selection" in the March 1952 issue of the Journal of Finance. This laid the foundation for what is now called Modern Portfolio Theory. He was the first to point out that a portfolio's risk could be reduced by including different types of assets, because different assets go up and down separately from each other.
Over time, Markowitz's ideas were incorporated into what's called asset allocation. This is a portfolio management technique where money is divided into separate types of assets, to take advantage of how their market prices could go up or down independently of each other.
Therefore, a portfolio consisting of both stocks and bonds was less volatile overall than a portfolio of either one or the other. Although diversification is not asset allocation itself, asset allocation is a plan for portfolio management which uses diversification to reduce risk.
The more types of assets, the less overall portfolio risk. Therefore, many asset allocation portfolios are very sophisticated combinations of equities, bonds, real estate investment trusts, stocks in many different sectors, of many differently sized companies, from many other countries, commodities, gold, Treasury bonds, corporate bonds, municipal bonds . . . and so on.
By now you're wondering how this makes Markowitz an undercover tool of the IRS. That's because of another aspect of asset allocation called rebalancing.
When a portfolio manager implements asset allocation, they split the money up into certain percentages of stocks, bonds, and the rest. Let's keep it simple, and say half bonds, half stocks.
Over time, these percentages will change. If stocks are in a bull market but bonds are going down, at the end of a year the portfolio might be 60% stocks, 40% bonds.
Since this combination does not optimize portfolio return for the degree of risk involved, the portfolio manager must sell some stocks and use the proceeds to buy some bonds. Then the overall portfolio will again be 50% stocks, 50% bonds.
The rebalancing aspect of asset allocation/Modern Portfolio Theory is why the IRS secretly awarded Markowitz its Medal of Honor.
Selling off securities that have appreciated in price means that you are realizing capital gains. That's a taxable event. Sell stocks or bonds that have gone up in price, and you owe the IRS more money at the end of the year.
To appreciate the IRS's debt to Markowitz, you have to think about the financial world in the early 1950s. It was nothing like today.
First of all, everybody old enough to buy stocks remembered 1929's Black Friday or at least its aftermath, The Great Depression that lasted until the U.S. entered World War 2 in 1942. Many Americans were still afraid to put their cash into banks, thanks to the bank failures of the 1930s. They sure weren't about to risk it in the stock market.
Those Americans who did own stocks, usually bought the shares of famous companies paying dividends, then held onto those shares, collecting dividends, until doomsday.
The average daily volume on the New York Stock Exchange was under 2 million shares traded. The Dow Jones Industrial Average in June 1952 when Markowitz's paper appeared was 280, still down about 25% from its 1929 high.
People just didn't have a speculative, buy and sell higher mentality. The last time that kind of mania hit Wall Street was the 1920s, and everybody remembered how that ended.
So those years were not a good period for the federal government collecting capital gains taxes from stock market investors. Investors bought and held . . . and held . . . and held. They didn't sell unless they had a desperate need for the money.
No sale of stock, no realization of capital gains, so no capital gains taxes due. The IRS understood that they had to convince Americans to buy and sell more shares of stocks.
Enter Markowitz and his paper, the eventual consequence of which was to establish the gospel of asset allocation and rebalancing. Instead of holding onto their stocks and bonds for dear life, and simply paying taxes on the interest and dividends they received, investors began to sell off a portion of their assets which had risen most in price.
Therefore, they realized capital gains, and therefore became liable for paying capital gains taxes. Some people do this once a year, but some actually perform this ritual quarterly.
Brokers also love rebalancing, because it also increases transaction costs -- that is, broker fees.
Nobody is telling the average investor that the large, professionally managed funds (pension funds, trust funds, endowment funds, and so on) whose asset allocation management techniques they are imitating are exempt from capital gains taxes. That means, they can chase after winning stocks without penalty, and sell their disappointments without penalty.
You and I have to pay capital gains taxes.
Everybody but lawyers has figured out that I'm exagerating about the "undercover IRS agent" part -- but not the effect of rebalancing on the check you have to write to the IRS in next April.
The next time your broker or financial planner advises you to rebalance your portfolio, remember this: rebalancing may not be a "secret plot" by the IRS, but it still enables the IRS to collect more money out of your pocket book.
Copyright 2007 by Richard Stooker
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