Academic journal article Financial Services Review

The Behavior Heuristics Responsible for Formation and Liquidation of Tax Holding Accounts

Academic journal article Financial Services Review

The Behavior Heuristics Responsible for Formation and Liquidation of Tax Holding Accounts

Article excerpt

(ProQuest: ... denotes formulae omitted.)


This article examines the behavioral biases that lead individuals to create accounts with specific characteristics when facing sizeable tax liabilities and the subsequent behavior to liquidate these accounts at the time of tax filing. We call the pattern of selection and subsequent liquidation because of prevalent behavior heuristics the tax liquidation hypothesis. According to Constantinides (1983), an investor who engages in optimal tax trading will hold a "cash account" for the purpose of tracking his or her net liability due at tax filing. Every transaction, with taxable implications, will have an effect on the balance of this 280 account, with subsequent gains causing an increase in holdings, while losses, which can be used to offset prior gains, will cause a decrease to net holdings. This behavior, described as "optimal tax trading" by Constantinides (1983), focuses on minimizing the individual tax burden by holding winners and selling losers; individuals should sell stocks that have lost value in the short-term while, holding onto stocks that have gained value until the stocks can be sold at the preferential long-term capital gains rate.

Behavioral research across disciplines has shown that individuals do not behave rationally or act in such a way that always maximizes their own self-interest. Shefrin and Statman (1985) explain the disposition effect as the suboptimal investor behavior of selling winners too soon and holding on to losers too long. The primary explanations for the disposition effect are prospect theory as proposed by the novel prize-winning research of Kahneman and Tversky (1979) and mental accounting as proposed by Thaler (1980), collectively referred to as PTMA. Under the PTMA framework, individuals exhibit loss aversion, an asymmetric response to losses and gains of equal sizes, and focus too narrowly on individual security results as opposed to portfolio results. These biases influence investors to behave in a manner that violates optimal tax trading as described by Constantinides (1983), and creates sizable tax liability due at filing.

Following the creation of a tax liability, as a result of portfolio turnover, an individual must make a decision on where to hold the proceeds until tax filing. It is likely that the choice of holding account varies according to individual risk preferences, investment horizon, financial sophistication, wealth, income, and relative magnitude of potential tax liability. Furthermore, the behavioral biases present will also vary by individual as well as magnitude, but the extant literature suggests we may be able to detect evidence of this behavior in assets with specific characteristics. This article holistically examines behavioral biases as they pertain to asset selection and explores the potential effects these biases may have on security returns. The tax liquidation hypothesis proposes that the behavioral heuristics that have been shown to exist will lead to a consistently identifiable pattern in certain asset classes. Confirmation of this hypothesis will require identification of likely holding accounts as well as a statistically significant relationship between return and volume characteristics and the deterministic variables.

The intent of this research is to link the rules governing U.S. tax filing, and optimal tax trading with the behavioral characteristics that influence the individual selection of "tax holding accounts." Section 1 identifies the rules governing tax filing. Section 2 reviews the theoretical optimal tax minimization strategy. Section 3 briefly explains optimal tax trading. Section 4 proposes the behavioral biases that cause investors to deviate away from optimal tax trading as well as the heuristics that influence cash account selection and liquidation. Section 5 presents the hypotheses, summarizes the data and methodology, identifies real asset classes that closely fit the desired characteristics and a brief empirical examination. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.