how to deal with the "wash sale" rule. If a taxable investor sells a security at a loss and purchases the same security within 31 days, the investor must net the sale price against the most recent purchase price rather than the original purchase price. In effect, the realized loss is disallowed and the unrealized loss is carried forward. One approach to dealing with the wash sale rule is to purchase similar but not substantially identical securities. For example, an investor who owns shares in Merck, a pharmaceutical company, might sell the shares of Merck at a loss and immediately reinvest in Pfizer, another pharmaceutical company. Switching from Merck to Pfizer will likely have little impact on the portfolio's risk profile. The other approach is to wait the 31 days. An investor could sell Merck, wait 31 days, and then repurchase Merck. This has the advantage of maintaining the portfolio's risk profile over time. However, for the 31-day interval a part of the portfolio is out of the market and underinvested in equities. Some investors will purchase equity index futures or exchange-traded funds as a way to maintain equity exposure. The drawback to this variation is that unwinding the hedge position may generate short-term gains if the market has risen during the 31-day period. Tax loss harvesting has two benefits. First, it generates additional after-tax return. Second, it reduces the risk of the portfolio. Tax loss harvesting generates the most realized losses in declining markets and fewer realized losses in strong markets. The investor utilizes the tax code flexibility to allow the IRS to share in losses but not in gains! Equity markets tend to appreciate and thus the ability to harvest losses from a portfolio declines with time. In our experience, an investor might realize losses of 10 percent of a portfolio in the first year, 7 percent in the second year, 5 percent in the third year, and declining amounts thereafter. Actual results will vary with market conditions. Losses will be larger in weak markets and smaller in strong markets. Even in modestly good markets there are usually some stocks or sectors that are doing poorly and provide the opportunity for tax loss harvesting. We believe that systematic tax loss harvesting applied to a broadly diversified portfolio is expected to cumulatively generate realized losses equal to 30 percent of the portfolio's initial value. About two-thirds of these will be short-term in nature. Tax loss harvesting will generally yield few losses after about five years. Table 32.7 shows how tax loss harvesting can increase after-tax return. Compare this to Table 32.1 that showed the growdi of a simple buy-and hold-strategy. Tax loss harvesting adds the most value when the investor is in bequest mode, thus able to eventually dispose of the assets in a manner that avoids capital gains tax liability. If the investor is operating in liquidation mode, then tax loss harvesting creates tax deferral but not tax avoidance. Losses generate tax savings but also reduce the portfolio's cost basis. Once the portfolio is finally liquidated, the reduced cost basis will generate a larger terminal tax liability. A tax loss harvesting strategy will create meaningful benefits for Mr. Smith because it fits nicely with his plan to eventually give his assets to his foundation. On the other hand, the Jones family would derive less benefit because the children will hold most of the family's equities by the time Mr. and Mrs. Jones die. The step-up in basis does not apply to equities held by the children in the grantor trust. We assumed the Joneses had no philanthropic intentions. We will add tax loss harvesting to the core equity portfolio. We can map out one last efficient frontier for Mr. Smith, shown in Figure 32.4. We applied the core and satellite portfolio structure and tax loss harvesting to the Jones family example as well and derived two new efficient frontiers, shown in Figure 32.5.