Insights From Author Stuart Lucas, 'The Taxable Investor’s Manifesto'

After the launch of his new book, The Taxable Investor's Manifesto: Wealth Management Strategies to Last a Lifetime, author Stuart Lucas joined me to discuss the strategies he recommends for both individual investors and financial professionals.

Most of our discussion aired on Morningstar's Investing Insights podcast, and here are some larger takeaways from our wide-ranging conversation.

Owens: Referring to the title of your book, it seems you reframe what nontaxable investors are, and you point out that investors who are paying taxes on income and capital gains have to think differently.

Stuart Lucas: Imagine a football game where one team gets a first down every 10 yards, but the other team has to go 15 yards. Each time the second team is successful, the referee congratulates them and then takes away a third of their gained yardage. Even if the quality of the players on the two teams is similar, the rules put the second team at a significant disadvantage. Recognizing this, their coach needs to think differently. To have a winning chance, he will prioritize different players. His play calling will be different. Otherwise, he is almost certain to lose.

Investing is like that football game: two teams on the same field but required to play by different rules. In the investment world, there are two fundamental differences between individuals and institutions: Institutions don't pay taxes and they don't die. I am confident that most investors with Morningstar do pay taxes and eventually we will all meet our demise. My book is a coach’s guide to investing on an unequal playing field.

Owens: We talk a lot about people's goals being the most important thing they should focus on for their investing versus market performance.

Lucas: The industry standard performance measures for financial assets were designed by academics and practitioners who didn't consider taxes. They chose, and most everyone accepts, time-weighted rates of return as the best way to measure results, regardless of tax profile. These are a perfectly useful measure of the performance in a tax-free world. But using time-weighted rates of return to measure the results of taxable portfolios is insufficient and can be woefully misleading. Their fundamental shortcoming for taxable investors is that time-weighted returns don't capture the tax impact of investment decisions. For us taxable investors, investment strategy design and investment decisions within the context of that design have tax implications. As a result, different portfolios with exactly the same time-weighted rates of return, if measured in aftertax dollars--the dollars we can spend or reinvest--can have enormously different outcomes.

Owens: Your book goes far beyond taxes, to useful information from the investing process itself and the power of cash flow, but you emphasize the role that unrealized gains in your portfolio can play over time. Can you please expand on that?

Lucas: If you have a stock or a portfolio with a cost of $100, a market value of $200, and a 25% tax rate, then you have a $25 deferred tax liability. That is a potentially great liability if you play your cards right because it's a bit like an interest-free loan. In fact, if the asset associated with that deferred tax liability is a dividend-paying equity, the dividends don't go to the government--they go to you. So, the deferred tax has a negative cost of capital.

The other key factors are tax structure, time, and compounding. In order to have deferred taxes, you need an asset with substantial long-term appreciation potential. For all intents and purposes, only equities fill that bill. Today, other sources of profits are taxed at much higher rates than long-term capital gains and they are taxed currently--muni bonds may be an exception. In order to take full advantage of deferred taxes, one needs a strategy of long-term compounding of appreciating assets on a tax-deferred basis. The right investment strategy is key to tax-efficient compounding.

That's why The Taxable Investor's Manifesto is not a book about tax. It's really about investing on that unequal playing field. It's also about incorporating cash flow management into investment strategy. Cash flow management can be either a big investment risk mitigant or it can make a modestly aggressive investment strategy downright dangerous. Individuals have much wider spans of spending or contribution options than institutions--so the potential impact of cash flow on portfolio risk is much greater. Institutions typically spend somewhere between 4% and 6% per year. Individuals, on the other hand, have much wider discretion. We might be saving 6% or spending 6%. Being strategic about cash flow management is a tool at our disposal that many institutional investors have limited scope to apply. Their spending rate is usually mandated by policy, by contract, or by law. Plus, the wider choice that individuals have is probably the most controllable aspect of personal financial management and is hugely impactful over time.

Owens: In the book, you mention the power of compounding, especially through equities. I think you make a great case for how equities are a superior long-term asset class.

Stuart: It's no secret that, historically, equities have outperformed fixed income or cash. But on an aftertax basis, that difference is expansively more profound. Equities--public and private--are really the only asset class that has the capacity to grow and compound on a deferred-tax basis. The vast majority of profits that one generates in a fixed-income portfolio are taxable every single year. Furthermore, taxes are payable on nominal profits, not real profits, so the greater the proportion of profits attributable to inflation, the more it hurts taxable investors. My book shows just how profound the differences are when you add up these structural considerations.

To unlock the full power of equities in taxable portfolios, you need a differentiated investment strategy--a different playbook. One of the interesting characteristics of capital gains is that once you achieve 365 days of ownership--thus converting from highly taxed short-term gains to the lower tax rate of long-term capital gains--the difference in the benefit of an incremental one-week, one-month, or one-year holding period is small until your investment compounds tax-deferred for 10 years or more. It’s only at that point where the incremental benefits of tax deferral really kick in. So, if I was going to invest in individual securities, I would seek out companies that I am comfortable owning for the next 10 years. That’s a pretty tough call because most great companies go through periods of extensive underperformance. Do you have the analytics and the stomach to stick with them through thick and thin?

Owens: Could you talk a bit about what you see as helpful to someone who's a few years into their first job and they're starting to feel like they might have a successful trajectory and will have some savings to work with--what's in it for them in terms of this manifesto?

Lucas: The fundamental messages of the Manifesto are applicable to all taxable investors. One of the most important is taking advantage of the power of compounding. Unleashing that power can be particularly impactful for young investors who are just starting out. Recently, I did some calculations for young tennis pros earning $35 per hour. If they work an additional 3.5 hours a week for 30 years and put the incremental income into an IRA, it can be worth more than $500,000 in retirement--a sweet complement to Social Security. The powers of compounding, time, and sensible investing turns $35 per hour into $300 per hour. Not bad compensation early in one's career.

Because sensible taxable investing is both simple and compelling, I want to help people start saving and investing early. They should start by allocating as much of their excess cash flow as possible into retirement funds, where they get the additional benefit of tax deferment. When tax rates are lowest, they should establish and fund Roth IRA, or Roth 401(k), because these assets pay no tax on the back end. As current earnings and the tax rate on those earnings rise, they may switch to traditional retirement plans where taxes aren’t paid up-front, but only in retirement. Those with more lucrative careers or successful entrepreneurial endeavors will one day layer in fully taxable savings to invest. These also can be efficiently managed for long-term growth.

Owens: Have you got any perspective to share with what seems to be a younger generation of investors who are opening brokerage accounts and diving into stock selection?

Lucas: While in high school, my son identified and invested in a Chinese shoe company because they had signed Dwayne Wade to a shoe contract. He still owns it, and it's up about 10 times. I, on the other hand, was trained as an equity analyst starting nearly 40 years ago and my 10 times batting average is a lot lower. Based on our respective track records, he is an infinitely better stock-picker than I am. However, just because you've succeeded once doesn't mean the trend will continue. Alpha is a zero-sum game, and there are large numbers of well resourced, highly intelligent, financially motivated professionals that individual investors like my son must compete with. Plus, as taxable investors, every time we cash in our chips from good investments, 25%-35% of the profits go to the government. Almost everyone is better off indexing, but some of us hate the idea of owning the averages--what indexing is all about--and stock-picking can be fun. The managers that Morningstar tracks build entire businesses around stock-picking. I have nothing against picking individual stocks or managers that pick stocks. But ask yourself the following questions: Am I trading stocks, ETFs, or active managers to maximize long-term returns or for entertainment? Do I have the metrics in place to tell the difference? How much am I willing to pay for entertainment?

Owens: Your book covers some scenarios relating to how business owners transition to owning financial assets and how inherited assets come into the picture. What insights do you offer those investors and savers who don't stand to inherit any assets, least of all a family business?

Lucas: The overriding message goes back to where our conversation started--death and taxes. Our parents are likely to live a long time. One of my favorite Morningstar charts tracks actuarial assumptions about life span. It tells me a couple each aged 65 has a one-in-four chance of living another 32 years. That's a long time to live in retirement, reliant on financial assets for your security. It's also a long time to wait for an inheritance. Whether you come from wealth or not, the answer is the same: Build your career, control your spending, start saving, and invest in equities when you are young, and be consistent. If you do, you will be amazed at how your savings will grow. With disciplined savings and effective long-term investing, you will build financial independence. Isn't that a good thing for everyone to strive for?

A second message is, once your system of savings and equity investing is established and implemented with discipline, benign neglect is useful. Let all those talented business leaders managing companies around the world be guardians of your capital and let the stock market do its work of capital allocation among them. You don't need to second-guess either of them. The powers of compounding and tax deferral have been pretty extraordinary for the last 200 years, and they are likely to be so for the foreseeable future. Low-cost indexing is a simple, responsible, tax-efficient way to capture and share in the value creation skills of those business managers. But for those who want to be more active investors, The Taxable Investor's Manifesto also shows you how to add value through active management and alternative investing, net of fees and taxes. My parting advice for those who are considering this second path is to do so with skill and skepticism, or not at all.

This article expands on an interview that aired on Morningstar's Investing Insights podcast and has been edited for length and space. Listen to the full episode.