Compounding My Interests has a great post highlighting some wisdom from Charlie Munger–a TRULY great investor.
The money shot:
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. 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.
Source: Munger’s On the Art of Stock Picking pg. 16
Just how “Eye-Opening” is the difference?
Let’s look at the stats from 11/1/1983 to 10/31/2013:
- col1 = 1.133^(1/12)-1 per month
- col2 = 1.0975^(1/12)-1 per month
- SP500 = S&P 500 Total Return Index
- LTR = 10-Year Total Return Index
First, you’ll notice that simply buying and holding the S&P 500 Index (and never selling) is better than running a tax inefficient strategy with 400bps of alpha over the past 30 years (SP was ~11.11% CAGR).
Amazing. Alpha is interesting; taxes are AMAZING.
You end up with $4,235.43 for the 13.3% strategy and $1629.81 for the 9.75% strategy.
$4k==> family vacation to Paris
$1.6k ==> family vacation to the in-laws…
Let’s look at the stats from 1/1/1927 to 10/31/2013 (note: not adjusting for time period to identify after-tax CAGR, just sticking with Munger’s 13.3% for simplicity):
Again, the tax-inefficient strategy earning 500bps+ of alpha per year over the past 82 years can’t even beat a buy and hold S&P 500 Index Fund at 9.86% CAGR (Go Jack Bogle!).
Taxes are everything; Alpha is nothing. Taxes and alpha are the shiznit.
You end up with $5,116,392.34 for the 13.3% strategy and $322,448.18 for the 9.75% strategy.
$5.1mm ==> Big Pimpin’ with Snoop.
$.32mm ==> NOT Big Pimpin’ with Snoop.
A dollar of tax-deferred, is a dollar that can be compounded.