Diversification in the presence of taxes - There are substantial risks incurred with concentrated holdings.

A common problem for taxable investors is how much to diversify either a lo w cost basis single-asset or concentrated portfolio. While tax-exempt theor y is clear on the benefits of diversification, and there are useful industr y methods for addressing this, in the presence of taxes there are no standa rd approaches to arriving at a considered choice. The authors propose an an alytic and intuitive framework for addressing the problem, considering only two investment alternatives. By defining a tax-deferred equivalent of the taxable investor, they are able to adapt standard analytical methods and vi ew the diversification decision in the presence of taxes as a conventional risk-return trade-off, provided the appropriate tax-deferred performance me asures are used. Greater diversification is needed with greater initial ass et volatility, with longer investment horizons, with lower expected return of the initial asset, and with a higher cost basis. Less diversification is needed when the investor receives a step-up in basis at the horizon. The r esults highlight the substantial risks incurred in concentrated holdings an d often support high levels of diversification, even in the face of taxes.