When’s a 10% return better than 11%?

In the quest to grow wealth, many people believe they have to seek out the highest return possible.

However, investors often overlook their real objective: to generate the most money after taxes. That’s why it’s difficult to believe that, over the long haul, you can actually become wealthier by owning a fund that generates a 10% annualized return with no turnover, as opposed to one that has an 11% return and 100% turnover.

Read: Reaching for yield, taking on risk

Here, we explore how the power of compounding and the tax system can be leveraged to help grow wealth over time.

A chess analogy

One of the tales about the invention of chess is also a memorable simile about the power of compounding. When the inventor showed the game to his king, the ruler was so pleased that he gave the inventor the right to name his prize. The man asked the king to receive one grain of rice for the first square of the chess board, two for the second, four on the third one, and so forth, doubling the amount each time. The ruler, arithmetically unaware, quickly accepted the inventor’s offer, but later realized it would take more than all the kingdom’s assets to give the inventor the reward.

Had the inventor asked for a penny instead of a grain of rice, he would have accumulated US$184 quadrillion, or more than 2,500 times the output of the entire global economy in 2013.

Read: 4 obstacles to high-yield returns

This story shows the power of compounding. But once numbers become very large, exponential growth becomes impossible in the real world. For instance, the largest companies in the stock market face challenges compounding their underlying value at above-average rates.

In fact, size is the enemy of high returns, and being small and nimble can remain a huge advantage when investing.

The trouble with taxes

But the story missed another real-world enemy of returns: taxes.

A key to growing real wealth is to leverage the tax system by:

• focusing primarily on investments that are taxed at lower rates, like capital gains; and
• delaying the payment of taxes whenever possible.

Read: Taxes and your investments

One of the secret ways the wealthy grow capital is that they tend to pay their taxes later through legal deferral. Savvy investors know the tax system can be used to make patient investors wealthier. Paradoxically, sometimes the investment with the lower pre-tax return produces greater wealth on an after-tax basis.

Consider two wealth scenarios for an investor with $100,000 at the start of a 25-year time horizon, who’s subject to a 21.85% tax on capital gains (the top tax bracket in B.C., 2014) and has managed to grow his capital at 10% annually.

• The Impatient Investor would have accumulated $656,115 in after-tax wealth after 25 years if he had 100% turnover and paid taxes each year on the gain.
• The Patient Investor would have accumulated $868,582 in after-tax wealth if he had put his capital into a single investment and held it over the same 25 years.

In this case, he would have realized more than $1,083,471 pre-tax after 25 years, and paid $214,888 in taxes in the final year.

Read: 7 tips to tax loss harvest

The tax system rewards the patient investor with 32% more wealth on an after-tax basis at the end of the period than his impatient counterpart—despite generating the exact same return on a pre-tax basis. The chart “After-tax wealth for $100,000 in 25 years” shows the impact of different pre-tax rates of return and turnover rates on after-tax wealth over our 25-year time period.

While few investors hold just one investment for 25 years, and tax rates can change, this tells us that tax-paying investors will realize a far greater sum from a single investment that compounds internally at a given rate, than from a succession of different investments compounding at the same rate.

Read: Most don’t know how investments are taxed

Plus, the higher the pre-tax annualized return and the longer the time horizon, the more an investor benefits from patience when measured by after-tax wealth. At a 15% pre-tax annualized return, the patient investor was 62% more wealthy, or almost $1 million richer, than his impatient counterpart. Clearly, not all pre-tax returns are equal for investors seeking to grow their after-tax wealth.

10% is better than 11%

Let’s solve the riddle in the title of this article: When is a 10% return better than an 11% return?

Using the same assumptions as before, the chart “Return required to…” shows the required pre-tax rates of return that an impatient investor needs to match to achieve the same after-tax wealth as his more patient counterpart. In fact, an investor who trades actively must generate an 11.56% return per year just to match the more patient investor’s after-tax wealth over a quarter century.

Read: Manage portfolios to fixed risk levels

Investor Warren Buffett has pointed out that long-term investors should think of deferred tax as an interest-free loan from the government. Unlike ordinary debt, investors get the benefit of more assets working for them, and:

• They have no monthly payments;
• They are charged no interest expense; and
• They get to decide when the bill comes due.

In other words, deferred taxes have all the benefits of regular leverage, but without the downside of debt. As long as people continue to hold their investments, they’re getting free money working for them that would disappear if they decided to move in and out of different stocks.

We believe this hidden form of leverage is a major reason wealthy people and successful portfolio managers are reluctant to sell winning holdings of great companies just to buy something slightly cheaper.

RRSPs

So far, we’ve only discussed the implications of patience for tax-paying investors. What about the investor with capital in a tax-free account, such as an RRSP, where a deferred tax approach is a given? Turnover in such an account does not make a difference from a purely tax perspective.

But it still pays to be patient. Numerous studies have found portfolio turnover and net returns tend to be inversely correlated. In other words, less active investors tend to make more money over time than the day-trading types.

Read: When to avoid RRSPs

Renowned investor Peter Lynch hinted at why impatience tends to lead to sub-optimal results when he opined that many investors “pull the flowers and water the weeds.” We think it’s helpful to keep in mind that the longer one holds onto any given stock, the more the investment results will reflect the underlying economics of the business.

The vast majority of wealth in the stock market is made by being patient with a relatively small handful of companies, which have favourable economics and high-return growth opportunities ahead. The fact that the tax system will provide a significant after-tax boost to such outperforming stocks is an added bonus for the patient investor.

While investors should water their investment flowers and allow them to grow, a word of caution: patience is not a substitute for an intelligent investing strategy. Investors also need to remain sensitive about valuation because overpaying will undo the value from the compounding itself.

Read: 6 common RRSP mistakes

We believe investors should consider small to mid-sized companies that compound internally at attractive rates that can be held for extended periods for performance-enhancing and tax-deferring reasons. Investors who appreciate that being small is helpful when it comes to compounding, and who understand that patience and low capital gain tax rates are key to leveraging the tax system, may find themselves wealthier over time.

Don’t just talk tax During RRSP season

Talk to clients about tax savings year round, says Jamie Golombek, managing director of tax and estate planning for CIBC Wealth Advisory Services.

During portfolio reviews, check if dividends are held outside registered plans since they’re tax-advantaged. Same goes for stocks, since only half of capital gains are taxed. Fixed-income vehicles, on the other hand, are best placed in registered accounts such as RRSPs, RRIFs and TFSAs, since interest income will then be sheltered. If people take advantage of tax credits and strategies, says Golombek, they can “invest in a tax-efficient manner over the long term.”

He also suggests advisors talk to clients about spousal loans, since the prescribed rate of the loans dropped down to 1% at the beginning of January 2014.

Spousal loans offer “the opportunity for a high-income spouse to loan money to a low-income spouse,” says Golombek. Then, the high-income spouse can “charge 1% interest on that loan [and is] able to income-split anything above that rate and have that [portion of income] taxed in the lower-income spouse’s hands.”

Maximize registered plans

Registered savings plans are easy giveaways from the government, says Golombek.

The problem, he says, is “we still meet…clients who haven’t opened [accounts such as] TFSAs because they say it’s too much trouble,” notes Golombek.

Regarding RESPs specifically, he suggests people do more than contribute the annual bare minimum of $2,500. Most stop at this amount, finds Golombek, since government grants (which are equal to 20% of the amount contributed) are capped at $500. People should aim to reach the $50,000 lifetime limit of RESPs.

Felix Narhi, CFA, is a portfolio manager at PenderFund Capital Management in Vancouver. He manages the Pender US All Cap Equity Fund. penderfund.com