On the importance of taxes in investing.
A version of the following article first appeared in the July 2013 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Investing is a lot like harvesting fruit from a tree. The typical investor, overconfident, ignores the smallish, plain but certain fruit dangling within his grasp. He’d rather clamber up the tree in search of bigger, sweeter fruit. So up he climbs, joining the other would-be fruit-pickers. More often than not, they all end up on a narrow branch that can’t support their weight. And they fall.
Sadly, many will pick themselves right up and clamber up the tree again. The smart ones are content to pick all the low-hanging fruit before attempting any acrobatics.
Everyone knows the low-hanging fruit: Diversify your holdings and keep costs down. Taxes are a big cost—perhaps the biggest for high-earners—but are also among the least thought about. I know from experience, because I haven’t thought nearly as hard about taxes as I have about other, ultimately less important things. Mea maxima culpa.
It's easy to show how important taxes are.
Patient Patty and Frenetic Fred are taxed at today’s highest marginal ordinary income tax rate, 43.4%. Patty is a Berkshire Hathaway BRK.B shareholder. Her favorite holding period is forever. Fred has an itchy trigger finger. He relishes harvesting short-term gains. Assume that over 30 years, the tax code remains the same (I’m aware I’m venturing into fantasy land here) and Berkshire earns 10% annualized without ever paying a dividend. After paying 20% on her long-term capital gains, Patty’s aftertax annualized return is 9.2%, for a tax-cost ratio of 0.8%. Assuming Fred only incurs short-term gains, how much would his portfolio have to return over this period before taxes to equal Patty’s performance? 16.3%. Unless Fred’s real name happens to be Warren Edward Buffett, the chances of him beating Patty after taxes are about as good as a paper dog catching an asbestos cat in hell.
Even if Fred paid only the 20% long-term gains tax on his earnings each year, he’d need a still-sizable 11.5% annualized pretax return just to break even with Patty. A 1.5% annual excess return over 30 years is like playing in the NBA—doable, but only for the elite.
Frenetic Fred is foolish because his fast-trading strategy fights the brutal arithmetic of compounding. For each dollar in taxes he pays today, he’s deprived of all the subsequent compound interest that dollar could have generated. And for each dollar he keeps, he has to pay taxes on whatever earnings they generate each year, and he forgoes the compound interest those taxed dollars could have generated. Fred, in his eagerness to pay taxes, plays the Grim Reaper, pruning each taxed dollar’s “family tree.”