Saturday, April 4, 2015

Investing should be boring

Trading stocks or having a high turnover of your stocks in your portfolio is expensive and reduces your overall return over the long term. You may have read about all those high MERs (Management Expense Ratio) and commissions for mutual funds which cause them to underperform the markets by nearly 50% over the long term. The example below compares the long term stock market return (6% plus 4% inflation) versus that of a mutual fund that performs as well as the market (87% under performs) minus MER and commissions estimated at 2.5% per year.  Well frequently buying and selling stocks in your portfolio is not a lot better!

What would your commissions be if you turned over your portfolio at least once per year? With a full service brokerage you’re charged 2-3% per transaction so a buy and sell costs you 6%.  Now add to that the taxes you have to pay every time you sell a trade. 

Holding on to a stock means you don’t pay capital gains taxes until you sell. This amounts to an interest free loan from the government. Say you held on to a stock that returns 10% per year in appreciation, after 7 years your investment has doubled, i.e. if you sold your investment half of your capital gains would be taxed at close to 50%. 

 If your original investment was $1000 then at 7 years it would be worth $2000. If you sell then $250 in capital gains taxes would be due (assuming a marginal tax rate of 50%)  plus 3% commission equals $60. When your $1690 would be reinvested at 10% ROI, then another 7 years later (i.e. in year 14) your $1690 minus 3% purchase commission would be worth $3279 minus capital gains taxes if you sold or $3279-$409.0=$2869.1
If you didn’t sell after the first seven years, then another 7 years later (i.e. in year 14) your investment would be worth $4000 minus capital gains taxes of $750 = $3250. Thus the government’s ‘interest free loan’ added nearly $381 to your profits or close to 38% of your initial investment and 17% of your total profits. On an after tax basis, via your discount broker, the picture would have been slightly prettier.

All Kinds of risk was posted on this blog in June 2010 and it shows some eye-opening stats on buying stocks for the short term versus long term investing. For your convenience, here is the key chart:
Commissions and taxes related to frequent buying and selling of stocks or investing in high MER mutual funds eat up a large portion of your future investment returns. So buy stock market ETFs or good companies that provide you good returns over many, many years. That may sound like a boring strategy but it makes you money. If you want excitement go play in a casino or work in the oil industry. J

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