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
Microsoft Excel - mungertax1


The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

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):

Microsoft Excel - mungertax

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

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.

I’d say that is pretty eye-opening…

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