In the quest to grow wealth, many people believe they have to seek out the highest return possible.
However, investors often overlook their real objective: to generate the most money after taxes. That’s why it’s difficult to believe that, over the long haul, you can actually become wealthier by owning a fund that generates a 10% annualized return with no turnover, as opposed to one that has an 11% return and 100% turnover.
Here, we explore how the power of compounding and the tax system can be leveraged to help grow wealth over time.
A chess analogy
One of the tales about the invention of chess is also a memorable simile about the power of compounding. When the inventor showed the game to his king, the ruler was so pleased that he gave the inventor the right to name his prize. The man asked the king to receive one grain of rice for the first square of the chess board, two for the second, four on the third one, and so forth, doubling the amount each time. The ruler, arithmetically unaware, quickly accepted the inventor’s offer, but later realized it would take more than all the kingdom’s assets to give the inventor the reward.
Had the inventor asked for a penny instead of a grain of rice, he would have accumulated US$184 quadrillion, or more than 2,500 times the output of the entire global economy in 2013.
This story shows the power of compounding. But once numbers become very large, exponential growth becomes impossible in the real world. For instance, the largest companies in the stock market face challenges compounding their underlying value at above-average rates.
In fact, size is the enemy of high returns, and being small and nimble can remain a huge advantage when investing.
The trouble with taxes
But the story missed another real-world enemy of returns: taxes.
A key to growing real wealth is to leverage the tax system by:
- focusing primarily on investments that are taxed at lower rates, like capital gains; and
- delaying the payment of taxes whenever possible.
One of the secret ways the wealthy grow capital is that they tend to pay their taxes later through legal deferral. 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.
Consider two wealth scenarios for an investor with $100,000 at the start of a 25-year time horizon, who’s subject to a 21.85% tax on capital gains (the top tax bracket in B.C., 2014) 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, he would have realized more than $1,083,471 pre-tax after 25 years, and paid $214,888 in taxes in the final year.
The tax system rewards the patient investor with 32% more wealth on an after-tax basis at the end of the period than his impatient counterpart—despite generating the exact same return on a pre-tax basis. The chart “After-tax wealth for $100,000 in 25 years” shows the impact of different pre-tax rates of return and turnover rates on after-tax wealth over our 25-year time period.
While few investors hold just one investment for 25 years, and tax rates can change, this tells us 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.
Plus, 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. 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 investors seeking to grow their after-tax wealth.