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Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

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INCORPORATING TAXES

When stocks in a portfolio appreciate or depreciate in value, capital gains (respectively, losses) accumulate. When stocks are sold, investors pay taxes on the realized net capital gains. The taxes are computed as a percentage of the difference between the current market value of the stocks and their tax basis, where the tax basis is the price at which the stocks were bought originally.15 The percentage is less for long-term capital gains (when stocks have been held for more than a year) than it is for short-term capital gains (when stocks have been held for less than a year).16 Since shares of the same stock could have been bought at different points in time (in different lots), selling one lot of the stock as opposed to another could incur a different amount of tax. In addition to capital gains taxes, investors who are not exempt from taxes owe taxes on the dividends paid on stocks in their portfolios. Those dividends are historically taxed at a higher rate than capital gains, and after 2010 will be taxed as income, i.e., at the investor's personal tax rate. The tax liability of a particular portfolio therefore depends on the timing of the execution of trades, on the tax basis of the portfolio, on the accumulated short-term and long-term capital gains, and on the tax bracket of the investor.

Over two-thirds of marketable portfolio assets in the United States are held by individuals, insurance and holding companies who pay taxes on their returns. (Exceptions ...

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