Arthur, I've compared notes with a number of traders, and have discovered what I believe to be a flaw in their conclusions about the superiority of trading. Before I get into the flaw, let me lay out some general ideas for you.
First, a trader will realize a maximum of 72% of his gains after taxes, while a buy and holder will realize a maximum of 82%. But this calculation obscures a more interesting phenomenon: buy and hold has the advantage of treating capital gains tax liabilities as a non-recourse, interest-free loan. Let me illustrate. Suppose the capital gains tax is 28% for both long and short term investments. Now suppose we are dealing with average portfolio growth of 30% per annum.
The trader will net 23.16% per annum after taxes under these circumstances. So, a $100,000 investment will be worth $802,965 after 10 years. But a buy and holder can do much better even at a 28% tax rate. The same investment will be worth $1,378,585 pre-tax after 10 years, and will be worth 1,020,581 after taxes. And if you care to calculate it, the annual rate of return works out to 26.15%. In order to equal that return, the trader would need to generate a pre-tax return of 36.32%.
Many traders tell me that they can easily beat that differential, but what they don't tell me is what period of time their capital is deployed in the market. Going back to the example just given, the required rate of return increases fairly dramatically if the trader is out of the market any length of time. For example, suppose the trader is out of the market for 10 weeks of the year. That means that he needs to generate 36.32% in 42 weeks. That implies an annualized rate of 46.76% for equality!
Finally, we come to the question of capital deployed. A buy and holder typically has close to 100% of capital deployed. but traders rarely do. That severely impacts total return, but most traders ignore that effect. One of the trick questions routinely asked of students in finance is which of two mutually exclusive investments would they choose: the first with an assured annual return of 10% and the second with an assured annual return of 15%. The question cannot be answered given this information, because the deciding calculation should be based on the net present value of the investment, which depends on the amount of capital that can be invested and the length of the investment.
Enough of my idle musings.
Good luck!
TTFN,
CTC |
