How Taxes Kill Your Investment Returns
Monday, November 20, 2006 | Dylan JovineRating:
This article, originally published around tax time this year, surprised us with the amount of feedback it received. It’s a very simple illustration of how much money you will lose over your lifetime trading in and out of stocks. It’s worth a second look as we gear up for another investing year. 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 value investing is 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 and Teeka. Indeed, I've seen what they can do firsthand, 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, in consequence, 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 commensurate 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.
(Please let us know what you think about Dylan Jovine's article.)
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Dylan Jovine
Chief Investment Officer
The Tycoon Report
MARK YOUR ECONOMIC CALENDAR – What’s ahead for the week of November 20th.
Monday, November 20th, 2006
10:00 Leading Indicators: Consensus 0.2%
Big Picture: Five declines to date in 2006 reflect the weakening economy as the 6 month growth has fallen in to a significant decline (-0.9%). Over the last 16 years the index correctly signaled the 1990 and 2001 recesssions while providing a false signal during the 1995 soft-landing. The recession alarms go off when the cumulative 6 month decline exceeds -1% amid a string of three or more consecutive monthly declines. No early warning bells yet.
Wednesday, November 22nd, 2006
8:30 Initial Claims: Consensus NA
Big Picture:
Category Nov 11 Nov 4 Oct 28 Oct 21 Oct 14
Initial Claims 308K 310 328 309 300
4-Wk Moving Avg 314 312 312 306 308
Continued Benefits 2443k 2443 2405 2442
4-Wk Moving Avg 2433 2434 2430 2439
10:00 Mich Sentiment-Rev.: Consensus 92.5
Big Picture: A strong lift from lower energy prices leaves the index near a 15 year high. Gasoline prices are the swing factor as strong labor conditions were being more than offset by high interest rates and global/domestic concerns. The U Mich survey is significantly smaller (500 phone calls) than the Conference Board's, includes a longer outlook (for expectations) as questions are focused on the household compared to the business heavy CB survey. The index far better tracks the consumers' mood than spending habits better indicated through interest rates and income growth.
(Source: www.Briefing.com)
