Musings on Performance – Don’t Forget Taxes (Part 2)

On many occasions, I have expressed my belief that market timing and associated short-term trading is counter-productive and hurts performance in the long term.  But there is another reason that penalizes a short-term trader even more — taxes.

All performance calculations are made before taking taxes into consideration.  This makes sense for general benchmarking and reporting purposes — every individual has a unique tax situation.  So reporting an after-tax performance of a mutual fund is not even possible.  However, taxes make a huge difference and have to be considered by each investor.

Here’s an example.  Suppose we have investors A and B, who achieve identical before-tax returns and are in the same tax bracket.  We will even assume that short term and long term capital gains taxes are the same.  The only difference is, investor A pays taxes on gains each year, while investor B pays them once at the end of investment period.  Who will have more at the end?

The answer is, investor B, and depending on rate of return, tax bracket, and the length of investment period, by quite a lot.  For example, assuming generous annual return of 15%, tax rate of 40% and 20 year investment period, investor A will grow $100K portfolio to approximately $560,000.  Not too bad.  Investor B, however, will have $1,021,000, nearly twice as much!  In real life investor B will pay smaller long-term capital gains taxes: if they are 20%, then he will end up with $1,329,000.

So, taxes should definitely be a part of overall performance measurement.  Don’t ignore them!  Taxes are a huge drag on performance for a short term trader — another powerful reason to be in the market for the long term.