Tax efficiency is critical to investing returns

One big reason why buy and hold works is because it is one of the most tax efficient investing strategies you can have.  For many people, taxes are one of their top 3 expense categories throughout their working and investing life, so reducing this expense as much as legally allowed is critical to growing your wealth.  As we have discussed before, focusing on the 2 or 3 largest causes of a problem is the most effective way to deal with the problem, via the Pareto principle.

If a large chunk of your returns in the market are taxed away, that is money you cannot use to further compound your investments, supercharging your portfolio growth over time.  Unrealized gains (gains you have due to the increased value of an asset you have not yet sold) are not normally taxed in the US, and the same goes for many other jurisdictions.  However, when the asset is sold, the taxes are due.  If you hold onto the asset for many years without selling, the taxes are technically owed at some point when you sell. However, you get to continue to use that money invested in the asset to work for you for many years to come, in the meantime.

Short term investing, on the other hand, suffers multiple negative hits when it comes to taxes.  Not only are taxes due at every sale when you happen to realize a profit, but you are, in most cases, taxed at the rate of your income which is often higher than the capital gains rate.  Dividends are usually taxed at a higher rate also, because they are non-qualified (qualified dividends require holding for a certain period of time around the ex-dividend date in order to qualify for preferable tax treatment in the US). Add to this, that if you have losses that are larger than your gains, you can only deduct losses up to the amount of your capital gains plus $3000 from income in the US – the rest of the losses must be saved for future year deductions.

So, in any short term strategy, you wouldn’t have to just outperform long term buy and hold strategies, which is hard enough, but you would have to outperform them by a wide margin in order to offset the extra taxes incurred.  Remember, that the only return that matters is your after tax return, not your before tax return.  

So, we have established that long term holding strategies are better. You can, however, take this tax efficiency for long term buy and hold strategies even further.  Many advocate for investing via index funds as the best approach to growing your wealth over time.  However, the S&P500 has a rather arbitrary set of rules and processes for which companies it includes and which companies it kicks out.  Let’s use the S&P500 index fund as an example due to its popularity.  The typical annual turnover of the S&P500 is 4.4%.  This means every year, roughly 22 of the companies must be sold and 22 new ones bought, incurring taxes on any realized gains.  After 20-25 years, you will have incurred capital gains taxes on 80-90% of your holdings due to this turnover.  Compare this to the situation where you constructed your own index and bought and held 20 or 30 stocks and didn’t ever sell for 50 years.  The extra compounding from saved taxes alone would be substantial!  This isn’t accounted for in any reported returns on these indices.

To illustrate these concepts, let us look at 4 different scenarios.  In each scenario, you invest an initial $10,000 and leave it invested for 50 years and you get a constant 12% pre-tax return each year composed of 10% in capital appreciation, and 2% in the form of dividends (all dividends are reinvested after taxes are paid for compounding).  Any short term gains are taxed at your income rate which we will assume is 25%, while long term gains are taxed at 15%.  These are very common tax brackets for most Americans.  Further, dividends are taxed at the qualified dividend rate of 15% for long term strategies, and at the non-qualified rate, 25%, for short term strategies.  This is consistent with the rules for how dividends would be taxed.  So, using this information, let’s examine what our portfolio looks like after 50 years.  For the baseline case of no taxes or expenses, you would turn your initial investment of $10,000 into $2.89 million, which is pretty fantastic.

If instead, you invested in an S&P500 index fund, you would pay taxes on the dividends and about 4.4% of the gains each year because of turnover due to adding and removing companies from the index.  You would also have management expenses of a miniscule 0.03% for this fund.  This would leave you with $2.42 million after accounting for taxes and fees – money which can no longer work for you and compound.  As you can see, your lifetime earnings dropped by over $400,000!  

Now, if instead, you created your own buy and hold index of high quality companies and held each diligently without selling.  Your turnover would be 0%.  Assuming you bought these companies in a no fee brokerage account, your expenses for management would be 0%.  After 50 years of compounding, your $10,000 would have turned into $2.53 million, over $100k higher than the case of using an index fund.  Most of this increase is due to the fact that you did not have to pay capital gains taxes on the unrealized gains of the stocks you held, instead continuing to use that money to work for you and compound over time.  You still paid taxes at the same rate as for the case of the index fund investment strategy on any dividend distributions you received.

Now, let’s look at short term investing.  Let’s assume, by some miracle, you are able to earn the same 12% as in the case of long term buy and hold strategies above.  This would probably not be the case in real life, but for this hypothetical situation we will assume that it holds.  In reality, you would also miss a substantial amount of the dividends that companies pay because you are buying and selling without being the shareholder of record on the date when you become legally entitled to the dividend, but we will ignore this and give our short term investor every advantage here.  After 50 years, you would have turned your $10,000 into just $590,863.  What happened!  That is so much less money (almost $2 million less than buy and hold strategies).  The reason is that you would pay taxes on 100% of your gains each and every year, and you would pay a higher tax rate of 25% for both dividends and capital gains.  Your expense ratio would likely be higher as well, although we will assume for our purposes here that you pay the same 0% that you would in a no-fee brokerage account.  You pay so much more in taxes and that is money that cannot be used to compound your investments in the future. These scenarios demonstrate that you can have very different after tax outcomes for your portfolio, even starting from the same pre-tax returns on your investment.

Turnover for index investing is a huge component of why I advocate for building your own star list of outstanding companies and investing in the ones that go on sale.  In the next post we will discuss even more aspects of why turnover in index investing is bad. But for now, suffice it to say, you want to buy and hold these businesses and ideally never have to sell them (as Warren Buffett says, the ideal holding period for a company is forever).

If you build a list with only tried-and-true companies that have shown the ability to earn durable and sustainable returns on capital, with outstanding balance sheets, good management, and otherwise good situations, you will decrease the chance that these companies will fail or perform poorly over very long periods of time.  By buying the best-valued of these companies available at the time, you ensure that you don’t overpay and get the best deal you can for your money by purchasing the most free cash flow for the least amount of money.  By holding indefinitely, you decrease turnover and capital gains taxes, allowing your money to compound more than in an index fund.  These headwinds all align to give you great returns over the long run vs. a standard index fund.  You still get all of the benefits of an index fund, but you are simply constructing your own index for maximum control and flexibility.

There is a further benefit of essentially constructing your own index that is not often appreciated.  By essentially building your own index from your star list of companies, you can optimize taxes across different investment accounts as well.  You will have taxable brokerage accounts, but you should also have at least some tax advantaged accounts such as an IRA, Roth IRA, 401k, or 403b, etc. You can use these to your advantage when choosing which investment to allocate to which account.

For example, for high dividend paying stocks, the dividend will be taxed.  You could place the high dividend stocks in your IRA or other tax advantaged account to prevent or delay having to pay taxes on the dividends.  You could place your high growth stocks that don’t pay dividends into your taxable investment account since, as long as you don’t have to sell, the growth would not be taxed for many years.  Some asset classes are taxed differently, such as trusts (oil trusts, real estate investment trusts, etc.), and bonds (treasury bonds, municipal bonds, corporate bonds, etc.).  By optimizing where you allocate these asset classes, should you choose to purchase them, you can further optimize your tax efficiency.  If, for example, you used this strategy to shelter all of the dividends from taxes in the long term buy and hold forever scenario above, you would have lost nothing to taxes reaping the entire growth of your $10,000 to $2.89 million over 50 years.  This would give you over $300,000 in additional lifetime earnings over the scenario where dividends were taxed.

Don’t forget that you should also be optimizing your taxable income as discussed previously.  You need to take maximum advantage of retirement accounts such as IRA accounts and 401k accounts to minimize your taxable income.  This will allow you to put even more savings to work compounding in the market, which should make an enormous difference in your wealth after decades of compounding.  Let us look at another example here.  Let’s say, in the baseline case that you save $1,000 per year for 50 years and earn the same 12% return as above (10% capital gains, 2% dividends) while buying and holding forever.  Your money would have grown to $2.32 million after 50 years.  But now let’s say that you utilize tax efficient strategies to save in your 401k and/or IRA.  The tax efficiency allows you to save an additional $1000 per year.  How much do you end up with?  About $4.81 million!  That’s an extra $2.5 million in portfolio value due to managing your tax situation efficiently. Note that you doubled your savings rate, and more than doubled your final portfolio value by utilizing tax efficient savings strategies.

As you save and invest, never ignore taxes, because they will have a massive effect on your after tax return and portfolio growth over the years.  There are many reasons why buy and hold works, and taxes is one of the big reasons why.  It is not an accident that most of the superinvestors typically have in common an unwavering commitment to a long-term buy and hold strategy. In the next post we will talk about even more reasons that a buy and hold strategy is adventageous for your long-term returns.