How Taxes Kill Your Investment Returns - Dylan Jovine

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How Taxes Kill Your Investment Returns

I am often asked why I invest for the long-term. Trading, folks argue argue, is the most logical way to invest your money.

Isn’t it smart to follow trends instead of wait for them?

Well yes….and no. Their are many reasons I don’t trade. Perhaps the biggest are a) I do not like to pay taxes, b) it 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.

And 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 Trades Each Year and 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

Yr.    Beg. 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, their the ones that know about the news of one of my portfolio companies earlier in the day then 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 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.

— By Dylan P. Jovine

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