Morgan Housel | The Motley Fool Investor: Errors in ignoring taxes

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Imagine you meet a genie who can grant you one of two wishes:

• A trading strategy that generates a guaranteed 20 percent annual return for the next 20 years.

• A buy-and-hold strategy that generates a guaranteed 14 percent annual return for the next 20 years.

Which one would you pick?

The obvious answer is the trading strategy. But it's wrong for most investors. The correct answer is the buy-and-hold strategy. Despite earning a far lower return, it finishes the 20-year period with substantially more money.

This isn't a trick question. The explanation is shockingly obvious: Taxes.

Capital gains earned in stocks held for less than one year are taxed as ordinary income — as high as 39.6 percent just for federal taxes. But profits on a stock held for more than a year are generally taxed at a lower rate — no higher than 23.8 percent, depending on your income.

Not only are long-term returns taxed at a lower rate, but because gains are only taxed after a sale, a deferred tax bill raises your account balance and increases the power of compounding. The effect is so powerful that a 14 percent-annual-return buy-and-hold strategy easily beats a strategy that earns 20 percent but is taxed each year.

You've probably heard about the percentage of mutual funds that don't beat an index fund. It's astounding — about 88 percent of actively managed stock funds have trailed an index fund over the last decade, according to Vanguard.

As lousy as those numbers are, they're worse when you factor in taxes. Since most active funds are constantly buying and selling stocks, tax bills can be passed onto their investors each year. And investors themselves buy and sell shares in mutual funds, generating capital gains if the fund has done well. Jeffrey Ptak, an analyst at Morningstar, recently crunched the numbers and showed that, after taxes are taken into consideration, about 96 percent of actively managed funds underperform a passive strategy over time.

Most investors find outperforming the market hard enough. But outperforming when Uncle Sam takes his cut each year is nearly impossible. The evidence shows that virtually no one can do it, since the excess returns necessary to beat a buy-and-hold strategy are so large. But how often do you hear that? The majority of investment brainpower is devoted to the highest investment returns earned as quickly as possible, period. That's where the money is (and the fees are). We treat taxes like a sideshow, but they alter real investment returns more than things like fees and volatility, which we obsess over.

There's more to add to this topic: Tax-deferred accounts like an IRA. Different income tax rates depending on your income. Strategically taking a tax loss as a write-off. The near-certain chance that tax laws and tax rates will change over the next 20 years. And a rational person might prefer the inferior trading strategy because it provides annual liquidity to buy stuff, rather than waiting 20 years for a payoff.

But Warren Buffett once said the goal of all investors should be to increase their after-inflation, after-tax wealth over time. It seems like such an obvious statement, but how did you answer the genie question above? The power of delaying taxes is more powerful than many investors think.

Things I'm pretty sure about

After writing about finance for the better part of a decade, the biggest change in my thinking has been becoming more skeptical of almost everything I see. Even the smartest people only know a fraction of what's out there. But I've become pretty sure of a few things.

• My biggest takeaway from economics is that the past wasn't as good as you remember, the present isn't as bad as you think and the future will be better than you anticipate.

• Investing is an epic battle between your goals, your temperament and the self-interest of middlemen. Problems are easier solved when you break them down into those three groups.

• The people who have added the most to financial journalism are those who aren't trying to impress anyone. They're having fun, and would be doing the same thing if no one were watching. No commercial incentive can replace the power of real passion.

• The first generation who grew up with the Internet is just now entering the workforce. They're capable of things the older generation can't fathom.

• "Save more money" is some of the best financial advice you can give, but it's not intellectually stimulating enough for smart people to take seriously.

• The most powerful trick is learning how to change your mind. But it's so hard. The resistance to admitting past efforts were wrong keeps people making poor decisions for longer than they need to.

• People who think the odds of getting sick are low enough to forgo health insurance think they have a shot at winning the Powerball, which says something about financial education.

• "The more the Internet exposes people to new points of view, the angrier people get that different views exist." — Ben Evans

• Everything is so obvious in hindsight. It's impossible to un-remember what you know today when trying to recall how you felt in the past.

• No one knows what they want. When things are going well, people say they want a bear market because it would be an opportunity. When it comes, they get nostalgic for the days when everything was going well. It's helpful to acknowledge that our emotions are driven by factors we don't anticipate when envisioning the future.

• Relative values are hard to deal with. We were just as shocked at how expensive $30 oil was in 2004 as we are shocked at how cheap it is today.

• No matter how hard they try, most people will extrapolate the past 12 months into the indefinite future when forecasting.

• There are now almost twice as many hedge funds as there are Taco Bells, which explains why the quality of each product has reached parity.

• To paraphrase Jon Stewart, the only reason you think the country was better during your childhood is because you were a kid.

• It always looks like we haven't innovated in 10 or 20 years because it can take 10 or 20 years before the masses notice an innovation.

• Everyone is half as rational and twice as gullible as they think they are.

• I don't know many people who are good at multitasking, but I know lots of people who think they are. Most of us would get more done focusing on one thing at a time, and doing it right the first time.

• The quality of free financial advice and commentary online is staggeringly good these days. It's a public service we often take for granted.


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