How Taxes Kill Your Investment Returns
Friday, April 21, 2006 | Dylan JovineRating:
As the "value investor" of this motley crew of investors who write for the Tycoon Report, I am very often asked why I invest for the long-term. Trading, they argue, is the most logical way to invest your money. Isn't it smart to follow trends rather than wait for them?
Well yes … and no. There are many reasons I don't trade. Perhaps the biggest are
a) I do not like to pay taxes b) Value investing fits my emotional disposition, and c) I think it's the most profitable way to invest for the long-term.
Over the next few articles I write, I'm going to discuss why I am a long-term value investor, and why I never pay attention to short-term trends. This is not to argue against our dear friends Chris & Teeka. Indeed, I've seen what they can do first hand, and it is quite impressive.
But it is important for you as investors to understand some of the key issues that make us different.
So with that in mind, today I'm going to focus on my desire to avoid paying short-term capital gains taxes.
How Taxes Kill Investment Returns
Paying taxes has a devastating effect on the power of compounding returns in your portfolio.
To show you just how devastating trading stocks (and by default paying taxes) can be on your portfolio, I've prepared a table below to illustrate.
The Power of Compounding Returns
(Or my alternative title, "How Taxes Kill Investment Returns")
Let's say that both Portfolio A and Portfolio B each begin with a $10,000 investment. In addition, each earns 20 percent each year. But while Portfolio A holds onto the same stock each and every single year for 10 years, Portfolio B does one trade annually (I won't even show how devastating multiple trades can be).
Portfolio A - Long-Term Holding with No Taxes Paid
| Year | Beginning Value | % Return | Taxes Paid | Yr. End Value |
| 1 | $10,000 | 20 | N/A | $12,000 |
| 2 | $12,000 | 20 | N/A | $14,400 |
| 3 | $14,400 | 20 | N/A | $17,280 |
| 4 | $17,280 | 20 | N/A | $20,736 |
| 5 | $20,736 | 20 | N/A | $24,883 |
| 6 | $24,883 | 20 | N/A | $29,859 |
| 7 | $29,859 | 20 | N/A | $35,831 |
| 8 | $35,831 | 20 | N/A | $42,998 |
| 9 | $42,998 | 20 | N/A | $51,597 |
| 10 | $51,597 | 20 | N/A | $61,917 |
| As you can see, at the end of year 10, the initial investment of $10,000 is worth $61,917, for a net gain of $51,917. | ||||
Now let's take a look at Portfolio B, where one trade is executed each year creating a single taxable event at a short-term tax rate of 40 percent.
Portfolio B -Account with One Trade Each Year and Taxes Paid
| Year | Beginning Value | % Return | Pre-Tax Amount | Taxes Paid | Yr. End Value |
| 1 | $10,000 | 20 | $12,000 | $800 | $11,200 |
| 2 | $11,200 | 20 | $13,440 | $896 | $12,544 |
| 3 | $12,544 | 20 | $15,052 | $1,003 | $14,049 |
| 4 | $14,049 | 20 | $16,858 | $1,123 | $15,734 |
| 5 | $15,734 | 20 | $18,880 | $1,258 | $17,541 |
| 6 | $17,541 | 20 | $21,049 | $1,403 | $19,646 |
| 7 | $19,646 | 20 | $23,575 | $1,571 | $22,003 |
| 8 | $22,003 | 20 | $26,403 | $1,760 | $24,642 |
| 9 | $24,642 | 20 | $29,571 | $1,971 | $27,600 |
| 10 | $27,600 | 20 | $33,120 | $2,208 | $30,912 |
| As you can see, at the end of year 10, the initial investment of $10,000 is worth $30,912 for a net gain of $20,912. | |||||
As you can see clearly here, taxes have a devastating effect on the compounding effects of returns on your portfolio. At the end of the ten-year period, Portfolio A has a total of $61,917. This is in stark contrast to the $30,912 in Portfolio B. The difference? One trade each year and the taxes associated with that.
It's no secret then why investing greats such as John Templeton, Warren Buffett and Ed Lampert have always preached the importance of finding great companies and holding them for as long as you can.
Having been fortunate enough to have "seen the light" (and the facts) at an early age, I've been practicing the same philosophy for years. That's why, much to the astonishment of many of my friends, I'm not glued to the screen each day waiting for news to hit the tape. Oftentimes, they're the ones who know about the news of one of my portfolio companies earlier in the day than I do.
To sum up my philosophy in one sentence, my goal is to buy a piece of a company that has great "natural" economics and to receive returns commiserate with the economics of the company over a long period of time.
If I never have to sell the company, and never have to pay taxes, I will be a very happy man.
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Dylan Jovine
Contributing Editor
The Tycoon Report
