Investing is an unconventional game. You are not only paid to be rational, you are also paid to be inactive. The markets will pay you more if you participate less and pay you less if you participate more. Let’s dive deeper:
First, the concept
We all know compound interest is dependent on three factors: time-period (N) , interest rate (R) and principal amount (P). So ,ideally, if two investors have the same p, n & r, the amount they earn at the end should be the same. And it is indeed true. But only in the countries where there are no taxes on investment return. But in the countries where investment returns are taxed as capital-gains at the end of the investment, we need to add one more factor to the concept of compound interest: participation rate (X).
Considering the same P, N and R, lower the X higher will the absolute returns. i.e. lower the churn in your investments, higher will be the absolute returns.
Simplifying, it a bit further: In a country that has a capital-gains tax, If Investor A has a lower churn in their investments than Investor B then Investor A will make higher absolute returns than Investor B, even if their principal amount, number of years and rate of return for their total investment career are the same.
Analysis & Outcome
Let’s try to answer the WHY by analyzing 3 different scenarios: long term holding, medium term holding and short term holding.
Assumptions:
– In all three scenarios, we will use the same principal amount of $100K, number of years 30 and pre-tax rate of return of 15%.
– Capital-Gains tax of 20%
– Long term holding: No churn, just 1 investment held through 30 years.
– Medium term holding: Switching to another investment every 5 years. Total of 6 investments in 30 years.
– Short term holding: Switching to another investment every year. Total of 30 investments in 30 years.
Outcome of long term holding
Total number of tax event: 1
Post tax absolute returns at the end of 30 years: $5,316,942
Post tax annualized rate of return: 14.16%
Effective annualized drawdown due to tax: 15% – 14.16% = 0.84%
Outcome of Medium term holding
Total number of tax event: 6
Post tax absolute returns at the end of 30 years: $3,505,540
Post tax annualized rate of return: 12.59%
Effective annualized drawdown due to tax: 15% – 12.59% = 2.41%
Outcome of Short term holding
Total number of tax event: 30
Post tax absolute returns at the end of 30 years: $2,995,992
Post tax annualized rate of return: 12.00
Effective annualized drawdown due to tax: 15% – 12% = 3%
NOTE: If you are interested in the detailed calculations, you can download the xls attached at the bottom of this article
As you can see from the analysis above, there is clearly a longevity premium paid to us by the market for being inactive and not churning our investments over time. The difference can be huge and cost you millions at the end of your investing journey.
Reason
The reason for this huge difference in absolute returns at the end is due to the number of tax events one creates due to portfolio churn. The more you churn, the number of times you have to pay taxes you pay along the way increases. And it shrinks your principal amount for your next investment and therefore reduces the absolute returns at the end of your investing journey.
Observations & Learnings
– Taxes can clearly make a huge difference and most of us don’t understand its implications. Therefore, we see that the average holding period of a retail investor is less than a year.
– There is clearly a longevity premium, so it would be wise to spend more time to look for an investment that you can hold on-to for as long as possible (ideally forever).
– For investments that would need regular churns like short-term bonds or any other fixed tenure investment, it would be wise to invest it through a tax-advantaged account. Doing so will not create a tax event as therefore not drawdown your principal amount for the next investment.
– We are wired to think about any sort of cash payout like compensation, dividends, returns in a pre-tax form. Perhaps it would be wise to create a habit to talk about money in a post-tax form. This overtime will provide a clear & realistic understanding of the outcome.
– Clearly, finding long term investments is a solution. However it is easier said than done. Finding such companies that have great room for growth for decades might be very difficult and require persistence & hard work. And even harder would be holding for decades.
Final Comment
It is quite clear that portfolio turnover creates a drawdown to the total return. And its impact can be huge. The only rational way to tackle it efficiently is to think long-term, analyze for long term, choose your investments that have potential to grow for long and once you do so, hold those investments for a very long time.
To practice very-long term investing, you can use one of the very efficient frameworks discussed here.
Other interesting blogs related to investing:
Buying a dollar for 50 cents : Talks about importance of buying a stock at a discount and a case study that provided a 151% return in 1.5 years.
Bought the right company at the wrong price : One of most important mistakes investors make and don’t even realize. You might be making it too!
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