If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.
In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%— or only 9.75% per year compounded.
So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening.
If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
Imagine that Berkshire had only $1, which we put in a security that doubled by year end and was then sold.
Imagine further that we used the after tax proceeds to repeat this process in each of the next 19 years, scoring a double each time.
At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad.
If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576.
Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000.
The sole reason for this staggering difference in results would be the timing of tax payments.
|Rate of Interest||100%|
|End of Year||Buy and Sell Strategy||Buy and Hold Strategy|
How Wealth Increased by 2641%
In buy and sell strategy, our $1 becomes $25,244 while in buy and hold it becomes $6,92,060.
Profit = 6,92,060 – 25,244 = 6,66,816
Percentage = (6,66,816 / 24,244) * 100 = 2641.48%
Buy and Sell Strategy
Frequent churning leads to more outgo of tax.
The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.
Investors should remember that excitement and expenses are their enemies.
Tax paying investors will realize a far, far greater sum from a single investment, that compounds internally at a given rate, than from a succession of investments, compounding at the same rate.
Moral of the Story
Holding stocks over long term increases our wealth significantly.