We believe that one of the biggest mistakes that long-term investors make is ignoring their selling discipline due to their concern about taking a large capital gain.

Long-term oriented investors, who hold stocks for years rather than days or months, have a natural advantage over short-term strategies when it comes to producing after-tax returns. Long-term holding periods reduce taxes by 1) allowing the compounding of pre-tax returns by deferring tax payments and 2) qualifying for the materially lower tax rates on gains generated over periods longer than one year.

These two items have a large impact on after-tax returns. If a top tax bracket investor invests $10,000 in a stock that appreciates by 100% over five years she will be left with $17,620 after paying federal capital gains tax and the federal Medicare surtax on net investment income (state taxes run an additional 0% to over 13%). If instead, our investor traded the same stock every six months while generating the same 100% return over five years, the lack of pre-tax compounding and the significantly higher tax rate would result in her being left with after tax proceeds of just $14,871.

By naturally taking advantage of pre-tax compounding and lower tax rates on long-term gains, the long-term oriented investment strategy generates cumulative after-tax returns over five years of 76% while the short-term trading strategy, while generating the same pre-tax rate of return, results in a cumulative after-tax return of just 49%. Or put another way, after five years, the long-term investor will have 18% more wealth than the short-term trader.

But while longer holding periods are a natural advantage at the portfolio level, they also produce a perverse incentive for investors to hold fully or even overvalued stocks due to concerns about realizing large capital gains.

The problem with avoiding taking large gains is that it is generally the most fully valued holdings in a portfolio that will have the largest unrealized gains. Worse yet, an investor who decides not to sell a position due to its large unrealized gain will find that this reason for holding evaporates if the stock falls, causing them to decide to sell not when the stock is at its high, but instead to sell after a decline. This resistance to taking large capital gains on successful investments undoes the natural tax advantage inherent in long-term investing.

In some ways, Warren Buffett, with his statements about his favorite holding period being “forever”, has provided comments in recent years that would seem to support investors’ reluctance to take large gains. But earlier in this career, when the size of his portfolio did not prevent him from being more opportunistic and he traded more frequently than he does today, Buffett made the following remarks:

“More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause… What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if the two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t, the latter course is superior. However, we find this is rarely the case.

It is extremely improbable that 20 stocks selected from say, 3000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives prevailing at a later date). If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change).

There are only three ways to avoid ultimately paying the tax: 1) die with the asset—and that’s a little too ultimate for me—even the zealots would have to view this “cure” with mixed emotions; 2) give the asset away—you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc.. either; and 3) lose back the gain—if your mouth waters at this tax-saver, I have to admire you—you certainly have the courage of your convictions.”

(Hat tip to John Huber at Base Hit Investing for the quotes)

A well-executed, long-term investment strategy will be naturally tax efficient over time. But the taxable gains it generates will come via sales of highly appreciated assets that create a lumpy, and sometimes large, series of tax liabilities. The key is for investors to not turn the basic tax advantage of long-term investing into a basic disadvantage by shying away from triggering large gains after they have worked so diligently to generate them.

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