Compound Your Face Off

My buddy Wes Gray shared one of my favorite investment mantras when he was interviewed on Patrick O’Shaughnessy's stellar podcast Invest Like the Best. Simply put... the goal for investors should be to:

"Compound Your Face Off" 

There is a lot of content outlining just how powerful compounding is on the interweb... Investopedia summarizes it well (bold mine):

Compounding is the process of generating more return on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. Compound interest can help your initial investment grow exponentially. For younger investors, it is the greatest investing tool possible, and the #1 argument for starting as early as possible. 

This post will outline the benefit further, as well as show some examples of how large this benefit can be when an investor is focused on maximizing their compounded return. I'll then finish with some thoughts on how investors can more effectively compound their returns through tax aware investing.

BACKDROP: THE MATH BEHIND COMPOUNDING

The compounding formula is straight forward enough:

Ending $$ = Beginning $$ * (1 + return) ^ total time frame of compounding

The most important aspect of this formula is the exponential benefit of time (i.e. compounding shifts gains from a linear path to one that becomes more and more rapid in dollar terms). The result is that the level of annual return can matter less to long-term results than the ability to reinvest at that level of return.

Example: Growth of $100 assuming 6% / 8% returns with no reinvestment and with reinvestment.

Example Cont'd: Difference in the growth of $100 at 6% and 8% returns with no reinvestment and with reinvestment

CAPTURING THE IMPACT OF COMPOUNDING

This isn't to say that the level of return doesn't matter. Not at all. While most investors can grasp that limiting the impact of taxes can increase the level of total returns captured, I am not as sure many investors truly understand how this benefit can increase over time. The below chart is my attempt to clearly articulate how tax efficient investing can increase the rate of return that becomes embedded in the compounding machine (I used lots of simplifications in the below including no dividends to deal with and assuming all gains are long-term at the highest 20% tax bracket). 

• The line corresponding to no tax is straight forward enough. If an investment returns 8% annualized, there are no taxes, and you reinvest all proceeds... you receive 8%. 
• If you sell at the end of each year and are taxed at a 20% rate, you receive 8% * (1- 20%) = 6.4%... also straight forward. 
• Where things get interesting are for those that can postpone taxes in the 'sell at the end' line. Here the annualized figure starts in a similar situation as sell annually (i.e. if your holding period is 1 year it is identical), but for each year you postpone the payment of taxes, the more returns can compound before paying them out. 

Thus, the annualized return captured by an investor shifts higher, getting closer to the return for an investor with no taxes at all than those taxed annually (in this example, the sell at end annualized return is 7.3% in year 30, closer to the 8% return of no taxes than the 6.4% return if taxed annually).

In each case, the investor is avoiding short-term capital gains (i.e. keeping their tax rate at the minimum level), but the result is still material. 

THE IMPACT IS LARGER PER UNIT OF RETURN IN BONDS

Stocks happen to be a very tax efficient asset class if done right. An owner of a stock for more than a year pays "only" 20% at the highest current tax rate. Things are much less reasonable in other areas of the market... notably with taxable bonds where all income is taxed at the investor's income tax rate. The chart below is an example of the impact for an investor assuming high yield bonds return the current yield to worst (5.5%) for the foreseeable future and that the returns are taxed at the top 39.6% tax bracket (5.5% return becomes a 3.3% return after taxes - and the taxes cannot be postponed for bonds in a taxable account). In this example, the impact of taxes on bonds is greater on a dollar per dollar basis than it is for stocks despite lower returns... in the stock example above, stocks returned 8% while in this example bonds returned 5.5%, but the variance moved from a $185 difference to a $232 difference.

The interesting comparison thus becomes stocks vs bonds. A buy and long-term hold investor only needs a 3.9% pre-tax annualized return in stocks to get to the same 3.3% after-tax compounded return over 30 years. In other words, at the highest tax bracket, the pre-tax returns for a long-term investment in taxable bonds needs to be 30% higher than for stocks to get the same after-tax return.

SOME INITIAL TAKEAWAYS

• Postpone gains: Do you really need to sell? If not... don't
• Rebalance efficiently: Rather than sell gains (tax event), perhaps just allocate future proceeds into holdings that have underperformed
• Use favorable structures: ETFs are a GREAT way to delay tax events for stock holdings (not so much for bonds)
• Put money into tax efficient accounts: Deferring taxes or paying all taxes up front (i.e. Roth) in a retirement account or utilizing a 529 plan for your kid's education expenses allows your money to compound at a higher rate
• Put tax inefficient assets /strategies in retirement accounts: if you're going to own tax efficient assets or strategies that require frequent rebalancing, put them in your retirement account 
• Allocate to tax efficient areas of the market: muni bonds are underrated for after-tax returns relative to both cash accounts and taxable bonds, while real estate allows the postponement of tax events forever (if you roll gains into new property), while reducing taxes on current income given interest deductions for residential property
• Exposure replication: I hope to share some ways to replicate tax inefficient structures using more tax efficient structures at some point in the near future