The Cost of Realizing Gains Too Soon

One of the most difficult decisions for an investor can be the timing of taking profits. Gains, after all, are the reason for investing, but realizing gains too soon can be costly. Investors who are too quick to realize gains can cost themselves the benefits that come with compounding.

Many investors turn to mutual funds in hopes that a well-managed fund will relieve them of the worry of deciding when to sell. But the rate at which funds buy and sell securities can have a big impact on their returns.

Then there’s taxes. Realizing gains incurs taxes on those gains, of course. Have you ever wondered over how many years you could have used those tax payments to generate future gains? We decided to find out what rate of return would be required to offset the taxes being paid with various frequencies of realized taxation.

What happens if you sell every year? Or every five years?

To get an idea, we assumed a 23.8% tax rate on all gains and calculated the return required to have a $10,000 initial investment reach $100,000 in 30 years. To keep things simple, we excluded short-term capital gains and the commissions paid in connection with each sale. Here are the results:

Segment Wealth Management Growth Rate Required to Offset Frequency of Trading

As you can see, the more you sell, the higher the growth rate needed to achieve the goal. Realizing gains every year requires a growth rate of almost 10.5%, while not realizing gains over the entire period requires a growth rate of less than 9%. Simply buying stocks and never selling will augment your returns by half.

More important, the chart shows that if your mutual fund has an annual turnover rate of more than 10%, the rate of growth required to offset that turnover rate goes up significantly.

This compounding effect also favors ETFs (exchange traded funds) over traditional mutual funds because ETFs typically have the lowest turnover. What’s more, most ETF activity is shed into the open market outside the confines of the fund’s accounting, which means they can remove securities from the lineup without declaring a taxable gain.

Let’s assume that two investors both own the S&P 500 ETF (NYSEARCA:SPY). It returns 9% annually for 30 years. Each investor starts with $10,000. One sells his shares each year in an attempt to buy it back lower. He pays taxes on the 9% gains each year, and reinvests all the cash he has remaining. Some years his trades may help him, but other years they may not. In the end, his average purchase price is the same as if he had done nothing, but the sales cause taxes to be paid prematurely, retarding the benefits of compounding.

Assuming no commission costs, the selling investor has $74,615 at the end of the 30-year period, while the investor with no trades has $132,676.

Of course, the selling investor has all his taxes paid, and the investor who didn’t sell still has a large unrealized gain. But the non-selling investor also is entitled to a step up at death, which means his estate could avoid the tax entirely. Even if he sold after 30 years, he would owe $29,196 in taxes, leaving him with $103,479.

As I mentioned, the math for compounding gets even more dramatic when you consider short-term gains and commissions, neither of which were included in the chart.

The point to this exercise is to show that decisions to swap one security for another should offer significantly greater opportunity than doing nothing, because the compounding effects from avoiding taxes are a significant part of the overall return.

That opportunity would have to be even greater still if you hold your investment for the rest of your life. The “step-up in basis rule” at death erases taxable gains for any heir, including a surviving spouse. If a death along the way results in the forgiveness of taxes, the results for the 30-year holding period ends up being even more dramatic.

As a result, any reinvestment by a frequent seller over the same period really needs to provide twice the potential return of the original holding. With stocks more than 90% correlated to one another, the certainty of paying taxes would often outweigh the uncertainty of a better opportunity.

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