The Paradoxical Secrets of Growing Real Wealth by Leveraging the Tax System
When is a 10% Return Better Than An 11% Return? To Discover The Answer to this Riddle, Read On…
Sometimes it is easy for investors to forget what they have set out to accomplish. In their quest to grow wealth, many people believe they have to seek out the highest return possible. However, what investors often overlook is their real objective: to generate the most money after taxes. That is why it is difficult for them to believe that they can actually become wealthier by owning a fund that generates a 10% annualized return with no turnover, than one that has an 11% return and 100% turnover over the long haul. Here we explore how the power of compounding and the tax system can be leveraged to help grow an investor’s wealth over time.
One of the tales about the invention of chess is also a memorable simile about the power of compounding. Its earliest written record is contained in the Shahnameh, an epic poem written by the Persian poet Ferdowsi between c. 977 and 1010 CE.
When the creator of the game of chess showed his invention to the ruler of the country, the ruler was so pleased that he gave the inventor the right to name his prize for the invention. The man, who was very clever, asked the king this: that for the first square of the chess board, he would receive one grain of rice, two for the second one, four on the third one, and so forth, doubling the amount each time. The ruler, arithmetically unaware, quickly accepted the inventor’s offer, even getting offended by his perceived notion that the inventor was asking for such a low price, and ordered the treasurer to count and hand over the rice to the inventor. However, when the treasurer took more than a week to calculate the amount of rice, the ruler asked him for a reason for his tardiness. The treasurer then gave him the result of the calculation, and explained that it would take more than all the assets of the kingdom to give the inventor the reward1. The story ends with the inventor becoming the new king.
Had the inventor of chess asked for a penny instead of a grain of rice and had he managed one double annually, he would have accumulated US$184 quadrillion after 64 years, or more than 2,500 times the output of the entire global economy in 2013. An impressive figure!
This story shows the incredible power of compounding. It also illustrates the impossibility of exponential growth over long periods. Once numbers become very large, exponential growth will eventually gobble up everything else and is therefore impossible in the real world. Not surprisingly, the very largest companies in the stock market face challenges compounding their underlying value at above average rates. Size is the enemy of high returns and being small and nimble can remain a huge advantage when investing. Besides size, the story missed another important real world enemy of returns that all investors must deal with sooner or later. Taxes.
A key to growing real wealth is to leverage the tax system by: 1) focusing primarily on investments that are taxed at lower rates like capital gains, and; 2) delaying the payment of taxes whenever possible. When it comes to taxes on capital gains, fortunately the “sooner or later” is usually up to the individual investor. One of the secret ways the wealthy grow their capital is that they tend to pay their taxes “later”. We are not referring to special tax havens or complicated strategies to reduce or defer tax, but to taking advantage of how the system works. This is something that is available to every tax payer. Simply put, savvy investors know the tax system can be used to make patient investors wealthier. Paradoxically, sometimes the investment with the lower pre-tax return produces greater wealth on an after tax basis. Herein lays one of the secrets of growing your wealth.
Let us consider two wealth scenarios for an investor with $100,000 at the start of a full 25-year time horizon who is subject to a 21.85% tax on capital gains2 and has managed to grow his capital at 10% annually:
- The Impatient Investor would have accumulated $656,115 in after-tax wealth after 25 years if he had 100% turnover and paid taxes each year on the gain.
- The Patient Investor would have accumulated $868,582 in after-tax wealth if he had put his capital into a single investment and held it over the same 25 years. In this case, the investor would have realized more than $1,083,471 pre-tax after 25 years, and paid $214,888 in taxes in the final year.
The example above shows the tax system rewards the patient investor, the one who found one good investment and held it until the end of the period, with 32% more wealth on an after tax basis at the end of the period than the impatient counterpart despite generating the exact same return on a pre-tax basis. The chart below shows the impact of different pre-tax rates of return and turnover rates on after tax wealth over our 25-year time period.
Obviously very few investors hold just one investment for 25 years, tax rates can change, etc. Nevertheless, what this tells us is that tax-paying investors will realize a far greater sum from a single investment that compounds internally at a given rate, than from a succession of different investments compounding at the same rate. It is worth noting that the higher the pre-tax annualized return and the longer the time horizon, the more an investor benefits from patience when measured by after tax wealth (e.g. at a 15% pre-tax annualized return, the patient investor was 62% more wealthy, or almost $1 million richer, than his impatient counterpart). Clearly not all pre-tax returns are equal for those investors seeking to grow their after tax wealth.
Next it is time to solve the riddle given in the title of this article: When is a 10% return better than an 11% return? Using the same assumptions as earlier, the chart below shows the required pre-tax rates of return that an impatient investor needs to match to achieve the same after tax wealth as his more patient counterpart. In fact, an active investor must generate an 11.56% return per year just to match the more patient investor’s after tax wealth over a quarter century.
Legendary investor Warren Buffett has pointed out that the true long-term investor should essentially think of deferred tax as an interest-free loan from the government. Unlike ordinary debt, investors get the benefit of more assets working for them, but: 1) they have no monthly payments; 2) they are charged no interest expense and; 3) they get to decide when the bill comes due. In other words, deferred taxes have all the benefits of regular leverage, but without any of the downside of debt. As long as investors continue to hold their investment, they are really getting free money working for them that would disappear if they decided to move in and out of different stocks. We believe that this hidden, but very real form of leverage is a major reason why wealthy people, as well as successful portfolio managers, are reluctant to sell winning holdings of great companies just to buy something else slightly cheaper.
So far we have only discussed the implications of patience for tax paying investors. What about the investor with capital in a tax free account such as a Registered Retirement Savings Plan (RRSP) where the “later” tax approach is a given? Turnover in such an account does not make a difference from a purely tax perspective. Of course, there is also no benefit from the lower capital gains tax rate. All capital will be taxed at the investor’s highest marginal tax rate when eventually withdrawn.
Nonetheless, it still pays to be patient. Specifically, numerous studies have found that portfolio turnover and net returns tend to be inversely correlated. In other words, less active investors tend to make more money over time than the day-trading types.
Renowned investor Peter Lynch hinted at why impatience tends to lead to sub-optimal results when he opined that many investors “pull the flowers and water the weeds.” We think it is helpful to keep in mind that the longer one holds onto any given stock, the more the investment results will reflect the underlying economics of the business. The vast majority of wealth in the stock market over time is made by being patient with a relatively small handful of companies that have favourable economics and a long runway of high-return growth opportunities ahead. The fact that the tax system will provide a significant after tax boost to such outperforming stocks is an added bonus for the patient investor. Investors should water their investment “flowers” and allow them to grow. A word of caution: patience is not a substitute for an intelligent investing strategy and investors should be constantly vigilant for any potential threats that might derail the magic from ongoing compounding. Investors also need to remain sensitive about valuation because overpaying will undue the value from the compounding itself.
At Pender, one aspect of our investment strategy is that we seek out small-to-mid-sized “compounders” that ideally compound internally at attractive rates that we can hold for an extended period for both performance-enhancing and tax-deferring reasons. Patience is a cornerstone to this strategy. We believe investors who appreciate being small is helpful when it comes to compounding and understand that patience and low capital gain tax rates are key to leveraging the tax system may find themselves more wealthy over time.Felix Narhi, CFA March 14, 2014
1 On the 64th square of the chessboard alone there would be 2^63 = 9,223,372,036,854,775,808 grains of rice, or more than two billion times as much as on the first half of the chessboard. On the entire chessboard there would be 2^64 − 1 = 18,446,744,073,709,551,615 grains of rice, weighing 461,168,602,000 metric tons, which would be a mound of rice larger than Mount Everest! This is almost 1,000 times the global production of rice in 2013 (471,000,000 metric tons). Source: http://en.wikipedia.org/wiki/Wheat_and_chessboard_problem
2 Assumes the top tax bracket in BC in 2014.