Mark to market: Are you making this mistake by not understanding compounding?
Mark explains why you should avoid breaking the chain of compounding.
Question:
Hi guys –
Good podcast as always. Something Mark said got me thinking – capital gains tax.
People are so concerned about paying taxes on capital gains. Why?
I hear this phase often, if you are paying more taxes you are making more money.
Isn’t this just the ‘cost of doing business’ in investing. Be great to have an episode on the taxes side of investing and psychology of it.
Answer:
Shani and I received this question in relation to the following podcast. I like this question because it is an opportunity to provide a reminder about compounding. Taxes are the price of success. But as you will see the timing of when you pay them will impact the size of that success.
It all comes down to compounding. Compounding is earning a return on a return. It is an oft cited and little understood driver of investment returns. The goal of every investor should be to minimise or eliminate any activity that breaks the momentum of compounding.
A frequently used analogy of compounding is a snowball rolling down a hall. As the snowball travels down the hill it collects more snow and gets bigger. As it gets bigger the speed increases and the larger surface area picks up even more snow. It gets bigger and bigger.
The reader question was on taxes but anything that slows the momentum of compounding impacts outcomes. Taxes, fees, transaction costs and investment losses all hold you back.
I modelled out an example using taxes. I understand the basis for the question. Taxes are owed no matter what. But the timing matters too.
There is an obvious benefit to holding an investment for more than a year to get the long-term capital gains discount. I haven’t bothered to model out this scenario since this is well understood. There is also a benefit for paying taxes when you are in a lower marginal tax bracket. I haven’t modelled this out either.
Scenario one
In scenario one I’ve assumed that an investor holds an investment for one year and one day. That captures the capital gains discount. It is then sold and a new investment is purchased.
That new investment is held for one year and one day. This process repeats over a five- and ten-year period. Each time an investment is sold and a new one is purchased the amount invested is reduced by the taxes owed.
Scenario two
In scenario two the investor holds the investment for the entire time and sells it at the end of the five and ten year period.
The return in both scenarios is the same and the investor is in the same marginal tax bracket. I’ve modelled this out for an investor in the 45%, 37% and 30% marginal tax bracket.
Below are the results:
Perhaps you are surprised by the results. Perhaps not. What this shows is the impact of breaking the momentum of compounding. I will use a simple example with round numbers to illustrate what is happening in the scenarios I modelled out.
You start out with $100 and double the investment each year. In scenario one I take away 10% of your profits annually and the remaining money gets invested. In scenario two I take away 10% of the profits after 2 years.
In the first scenario in year one the $100 turns into $200. $10 is taken away of the $100 profit leaving a total of $190. The $190 is doubled to $380. I take away 10% or $19 which leaves $361.
In the next scenario the $100 doubles to $200. Then it doubles again to $400. I take 10% of the profits of $300 which leaves $370.
I’ve exaggerated the returns which shows the impact of breaking the chain of compounding.
There is value in delaying taxes which means there is an advantage to longer holding periods. Many investors give up this advantage far too easily. Keep visualising your portfolio as that snowball rolling down a hill.
Think of all the things that slow the momentum of the snowball and avoid them at all costs. This includes taxes, fees, transaction costs and permanently losing money on speculative investments. Pushing all of these into the future helps.
Even small changes in momentum will make a big difference in how far that snowball rolls and how big it gets. Investors that don’t forget that end up in far better places.
If you have a question you’d like to ask Mark, you can email him at [email protected]
