Compounding and Taxes

From: [url]http://market-mousetrap.blogspot.com/2013/01/01042013-compounding-and-taxes.html[/url]

Some years ago a number of things happened in the stock market (other than a few painful crashes).

1) Decimalization
2) Reduced Capital Gains Taxes
3) More Frequent Trading

Decimalization is here to stay. Capital Gains Taxes have just been increased. But what about that third item? Just how frequently will investors trade?

I’m not saying that investors will actually calculate their optimal taxes and holding periods. But they don’t have to plan in order for it to change on its own: those who trade too often will end up with less money to trade, so the increase in capital gains taxes will automatically force money to trade less frequently in the stock market.

Some weeks ago I mentioned an old truth that will become painfully obvious over time: “the more you trade, the less you have.”

That SHOULD be what we call the “Buffet rule.” But Warren Buffet has destroyed his investing legacy by advocating nonsense about capital gains hikes that he’s always been expert at personally avoiding.

So I won’t call it the “Buffet rule.”

I’ll call it the “Clontz rule.”

So here it is:

The Clontz Rule: “The More You Trade, The Less You Have.”

Granted, you DO need to trade at a certain frequency, but that frequency is not yet known.

For a short term trading period, my model targets between 60 and 70 days (hence my once a week rotation through ten stocks). But the change in tax rates has created a whole new environment.

Trick Question: if you hold forever and never sell, what annualized tax rate will you pay?

Nope, it’s not 0%. You’ll actually pay 43.80% on your dividends, which is about 3% of your holdings. Let’s just round it to 1.5% taxes on your total holdings.

Okay… here’s another trick question: what is the effective long term capital gains rate?

Nope, it’s not 23.80%. If you hold longer than a year, you won’t pay anything until the NEXT year, will you? Here’s how it breaks down:

Years Growth Taxes Annualized Dividend Taxes Effective Tax Rate
0 43.80% 43.80% 1.50% 43.80%
1 23.80% 23.80% 1.50% 25.30%
2 23.80% 11.27% 1.50% 12.77%
3 23.80% 7.38% 1.50% 8.88%
4 23.80% 5.48% 1.50% 6.98%
5 23.80% 4.36% 1.50% 5.86%
6 23.80% 3.62% 1.50% 5.12%
7 23.80% 3.10% 1.50% 4.60%
8 23.80% 2.70% 1.50% 4.20%
9 23.80% 2.40% 1.50% 3.90%
10 23.80% 2.16% 1.50% 3.66%
11 23.80% 1.96% 1.50% 3.46%
12 23.80% 1.80% 1.50% 3.30%
13 23.80% 1.66% 1.50% 3.16%
14 23.80% 1.54% 1.50% 3.04%
15 23.80% 1.43% 1.50% 2.93%
16 23.80% 1.34% 1.50% 2.84%
17 23.80% 1.26% 1.50% 2.76%
18 23.80% 1.19% 1.50% 2.69%
19 23.80% 1.13% 1.50% 2.63%
20 23.80% 1.07% 1.50% 2.57%

So, if you hold SPY for 20 years and then cash out – your effective tax rate is 1.07% annualized growth taxes, plus 1.50% annual dividend taxes, which equal an effective annualized tax rate of 2.57%.

I should add at least 2% inflation in there, since that’s a tax too, so let’s round it out to 4.57%.

In any case, here’s how it looks on a chart:

[ATTACH=CONFIG]16815[/ATTACH]

Our new enemy, Warren Buffet, has even figured out how to avoid dividend taxes. Just buy the entire company. He brags about that trick in his essays.

We can’t do that, so we’re stuck with the dividend tax hike (which was increased from 15% to 43.80%).

While I was bouncing my colicky newborn on my knee at 3am it occurred to me that I really had no idea WHAT the optimal holding period is on a taxed account. SO FAR it’s around 60 days, but that could change when I have a few more months of data:

[ATTACH=CONFIG]16814[/ATTACH]

In any case, it’s rather clear where the technical strengths of my model end and the fundamentals begin. I’ve tweaked the graph to account for the effective compounded tax rate, which shows the green taxed line progressively closer to the blue IRA line.

It appears that the Obama tax hikes will ultimately break my model into two: one for an IRA account and one for a taxable account. When that happens I’ll have an IRA model that adapts fundamentals to a fixed technical environment, and a second taxable model that adapts technicals to a much longer holding period. I should be able to nudge the gain rate on long term holds a bit higher still… once I have an initial fundamental peak to target.

I do not yet have a fundamental peak. That’s a good thing. The longer it takes to reach a fundamental peak the less taxes will ultimately be paid in future years.

My guess is that by raising the Capital Gains tax RATES, the government will end up with about a third of the REVENUE it previously collected.

But I can’t calculate that yet. Not enough data. There may be some historical data out there, but it’s not necessarily relevant to my model. My goal is to optimize my annual realized return rate, after trading costs and taxes are taken into account.

Obama has made his move.

Now it’s my turn.

Tim