In case it hasn't been clear up to now - my pal's concern isn't exactly this. His concern is that the central net return expectation doesn't provide sufficient reward for the downside risk. Otherwise put, if he got to retain more of the upside, he'd be much more accepting of the downside risk. [He would say something like - when I lose money I lose all that money but when I win money, I only win a part of that money and this retained part doesn't seem sufficiently attractive.]
OK. Two points.
Firstly, volatility is irrelevant here. An asset can be volatile, and still deliver high returns — indeed, volatility and return tend to be positively correlated. There may be good reasons to be concerned about volatility, but this isn't really one of them.
Secondly, it;'s not entirely correct to say that the upside is taxed and you only get some of it, but you bear all of the downside. If we're talking about investment in equities via a pooled, managed, fund, the fund gets a significant part of its return in the form of capital appreciation of the underlying shares. But, share-by-share, it experiences both gains and losses, and of course the losses are set off against the gains. The return you get from the fund is net of both gains and losses, so the losses do go to reduce the tax you would otherwise pay; you don't bear them all yourself.
If we stand back from this, there comes a point when nobody would be excited about investing in equities (in a pooled/insured type structure) - say, where the current 41% tax became 51% or 61% or 71%. Everyone would have their "it doesn't seem worth it" point at some stage. My sense is that his "doesn't feel worth it point" is lower - but maybe by not that much - than most people.
You can ask the same question about income tax — at what point is income tax so high that you just won't bother to work? Or, indeed, any tax — the whole point of swingeing excise on tobacco is to lead you to choose not to smoke.
But you can't ask the question "is it worth it?" without knowing what the alternative is. When we're looking at the marginal income tax rate, the alternative to working longer hours or taking a promotion to a more demanding (and higher paid) position might be more leisure time or less stress. How much does your employer have to offer you to induce you give up the leisure/accept the stress? The higher the marginal income tax rate, the more the employer will have to offer, and of course the amount will be different for different people in different circumstances.
So, what's the alternative to your friend investing his stash in equities? If we rule out cash in a shoebox under the bed, a series of really good holidays, and putting it all on the second favorite at a race meeting next weekend, the alternative is likely to be investment in other asset classes. But they, too, attract tax at the same 41% rate. Even if the rate were reduced to, say, 20%, that would affect both the equity funds and other funds, so it's probably not going to shift the dial hugely in terms of which asset class he prefers.
I think there's a bigger issue if we don't rule out the non-investment alternatives. Let's say your friend could spend his money putting an extension on the house. That would add some value to his house, but value he could only access by selling the house, which he might prefer not to so, so the financial benefit would perhaps accrue to his heirs rather than to him. The added value, and appreciation of it over time, would be tax free, because this is his principal private residence. And there'd be a non-financial benefit to him; he'd have a bigger house — room for the home gym that he always wanted, or whatever.
Here, because on of these options suffers tax and the other does not, tax rates might be a factor that would sway his decision.
But here's the thing. From a public policy point of view, do we care what decision he makes? He will make whichever decision maximises his own utility; do we have a preference as to which decision should maximise his utility more?
Plus, if we think his decision is being unduly swayed by the different tax treatment, the rational couse is to withdraw the CGT exemption — that, rather than the tax on the return from the managed funds, is the anomaly here.
