On this Thanksgiving, I’m thankful for the wisdom of Charlie Munger and the miracle of tax-efficient compounding. Charlie is Warren Buffett’s plainspoken and less-famous partner. This is his quote on the simple but stunning power of tax-efficient compounding:
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
This isn’t exciting to talk about, but it is where the rubber really meets the road in terms of investment success. 3.55% per year outperformance after taxes is incredible, and you don’t have to pay a hedge fund “2 and 20” to get it.
Wes Gray at the Turnkey Analyst does the math on how much difference this can make on an initial investment of $100 over 30 years:
Alpha is interesting; taxes are AMAZING.
You end up with $4,235.43 for the 13.3% strategy and $1629.81 for the 9.75% strategy.
This should be in neon lights. The tax-efficient strategy gives you a 4,235.43% return over 30 years, while the tax-inefficient strategy gives you a 1,629.81% return over 30 years. That’s up more than 42 times versus up more than 16 times. On a $10,000 initial investment, that’s a 30 year total of $423,543 versus $162,981. Stunning results.
Alpha is investment-speak for risk-adjusted outperformance of a benchmark. It is the Holy Grail for which all investment managers aim. But the impact of taxes is more important and less talked about. Turn off the noise on CNBC and focus on maximizing your after-tax return. It may not make for exciting dinner-party conversation, but what matters is not what you earn, it’s what you keep.