When making investment decisions, it is important to focus on the purchasing power and take into account the impacts of taxes and inflation. Surprisingly, most professional portfolio managers do not pay enough attention to after-tax returns or inflation rates. Frequent trading can also erode investment gains due to higher tax rates on short-term capital gains. Therefore, long-term investment strategies usually have tax advantages compared to short-term trading. In addition, where and how you hold your investments can significantly influence the ultimate compounding rate. For instance, you should always contribute enough to receive full employer matching benefits for retirement accounts, which provides risk-free returns.
Most managers ignore after-tax returns and inflation rates
The article points out that few professional portfolio managers focus on after-tax returns rather than pre-tax returns. They also often ignore the inflation rate when evaluating investment performance over time. However, taxes and inflation can substantially reduce investors’ actual wealth growth. For investors subject to high marginal tax rates, frequent trading strategies often lead to poorer long-term results compared to more tax-efficient approaches, even if the pre-tax returns are higher.
Long-term investment provides tax advantages
The article explains several tax benefits of long-term investing compared to short-term trading. For instance, short-term capital gains are taxed at ordinary income tax rates, which can exceed 50% in some cases, while long-term capital gains are typically taxed at much lower rates between 0-23.6% at federal level. In addition, unrealized gains can continue compounding without triggering tax events. Frequent trading not only incurs commissions but also loses this tax-deferred compounding potential.
Investment account type and asset location matter
The article emphasizes that where and how you hold investments can impact after-tax returns. For example, you would not hold tax-exempt municipal bonds in a Roth IRA account. Careful asset location across different account types – taxable, tax-deferred, and tax-exempt – can optimize overall after-tax returns. Another key recommendation is to always contribute enough to retirement accounts to receive full employer matching benefits, which provides an instant 100% risk-free return.
Do not overlook stable assets as inflation hedge
While many focus on high-return investments, the article reminds investors not to overlook stable assets such as Series I savings bonds. Though less exciting, they can provide valuable inflation protection and diversification benefits for a portfolio. A balanced and diversified portfolio should include both higher-risk, higher-return investments and more stable assets to manage risk appropriately.
In summary, when evaluating investments for the long run, it is essential to focus on purchasing power and consider the impacts of taxes and inflation. Thoughtful investment account selection, asset location, and portfolio diversification can help maximize after-tax returns over time.