HowWealthWorks.com

[Dave]

Investors make 25% more than traders

Compound interest is fascinating
I'm fascinated by what Albert Einstein called “the greatest mathematical discovery of all time.” Compound interest. Richard Russell once wrote that early in investing, compound interest is boring but, after 7 or 10 years, compound interest becomes absolutely fascinating. Color me fascinated. This fascination has led me to wonder what the difference in total return is between letting my investments compound unrealized and realizing my gains every year or more (so I pay lower long term capital gains taxes). I've also wondered what the difference in total return is between buy and hold and realizing my gains every year at the short term capital gains tax rate I've approximated at 28%.

A note about tax rates: long term capital gains taxes are pegged at 15%, but short term gains are taxed at ordinary income rates. I've approximated the short term rate at 28%, which is the bracket for income between $74,200 and $154,800, because this is where the majority of tax payers fall.

Investors pay long term capital gains and traders pay short term capital gains
Much has been written and argued regarding the difference between trading and investing. I'm only interested in the quantifiable differences: unrealized gains vs. realized gains and short term gains vs. long term gains. The qualitative differences between traders and investors I leave up to you. Below, I consider three cases for realizing your investment gains: 1) you buy and hold for five years; 2) you buy and hold for one year, realizing your gains for five years running; and 3) you buy and hold for less than a year five years running. In each case, I assume a 10% annual return compounded monthly.

If you're wondering whether I have a bias, you should know that I'm an investor. The average holding period for my investments is something like four years, and before this precious metals and resource bull is over, it'll probably be longer. I am not the type of person that is looking to jump from one asset to another, looking to make some “Fast Money.” Many people make “Fast Money,” but I'm not one of them.

1) Buy and hold at 10% for five years
If you buy an investment with a 10% annual yield that compounds monthly, hold it for five years, and then sell it, your total pre-tax return will be 64%. After tax, your total return will be 54.9%.

2) Buy and realize gains every year at long term capital gains rates
If you buy an investment with a 10% annual yield compounded monthly, and realize your gains every 366 days, your total after-tax return will be 53.16%. This rate of return is only 3.2% lower than buy and hold for five years. This means that, in order to equal the return of buy and hold at 10% for five years, you need make 10.32% return. If you're like most people, you're probably surprised by the small difference that realizing gains every year at long term rates makes.

3) Buy and realize gains every year at short term capital gains rates
if you buy an investment with a 10% yield compounded monthly, and realize your gains every 365 days, your total after-tax return will be 43.7%. This rate of return is 20% less than that of investors, or put another way, buy and hold 10% for five years returns 25% more than realizing every year at short term capital gains tax rates. This is also a good illustration that 25% up is equal to 20% down-- something many folks in the real estate market will become very familiar with.

Conclusions
Traders need to make 25% higher returns
Well, it seems the old fable of the tortoise and the hare is true in investing. If you're a trader, you need to hit the ball 25% harder than a buy and hold investors like me. If you are a trader, only you know whether this is possible, and how much effort it will take.

Don't fear realizing gains at long term rates
What should surprise you is this: realizing your gains every 366 days at long term rates only puts a 3% drag on your return. What is more important than not realizing gains is avoiding short term gains tax rates. This point should give you some comfort if you've been worrying about rising short term gains tax rates. If you've been reading the news, you know that once again, capital gains interest rates at in play. There is a good chance, in my opinion, that the 15% long term rate will be changed to some higher rate. In fact, there is some talk of doing aways with long term capital gains taxes altogether. If this happens, I'll probably be forced to realize gains before the rates rise (if my investments are grandfathered in, which they may be).
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Dave

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