There are two two things investors can control in the market and when it comes to managing their portfolios.
Firstly, investors have complete control over costs. If you don’t want to pay 2% per year to a broker or investment manager, there’s no need. Just find someone else, switch to a lower cost fund or invest some money educating yourself. The second controllable factor is diversification and position sizing. You have complete control over how much weight you want to give to each asset within your portfolio. Apart from these two factors, there’s little else the average investor can control. Portfolio values are at the mercy of the market, and as any seasoned investor will tell you, even if you think you’ve reduced your chances of being wrong by conducting rigorous due diligence, there’s no certainty that the company has been telling the whole truth. One controllable factor on the cost side of the equation is taxes. Everyone has to pay them, but you can minimize your obligations through sensible investment decisions. Capital gains and income taxes can be kept to a minimum by looking to the long term, not overtrading and being aware of what you can and can’t do.
Keeping costs to a minimum
It is true that most investors love dividends, but it’s also true that dividends are extremely costly for tax purposes. Assuming a US corporate tax rate of 35% (excluding state taxes) and dividend rate of 20% (higher rate) $100 of pre-tax income will fall to $65 after tax at the corporate level and $52 if all income is paid to shareholders.
This top-down big picture view might not mean much to you as the average investor, but over time it will hit a company’s growth. Big dividend payers don’t tend to grow as fast as non-dividend payers because they’re paying out not investing their capital. When the taxman collects such a large percentage, it seems to be a waste of time and effort. The timing of the dividend is another issue. A dividend payout usually takes place whether a shareholder wants it or not, giving you a potentially significant tax liability if you like it or not.
The best way to minimize these obligations is to invest for the long term in a company that reinvests and does not payout profits. Berkshire Hathaway is the best example. Warren Buffett (Trades, Portfolio) perfectly understands that the reinvestment model is the perfect way to protect and maximize wealth creation. To make the most of this strategy, it will pay to buy a compounder and sell a percentage if and when you need the additional income. Not only will this strategy limit tax on dividend income but it will also reduce trading and capital gains taxes. Of all the compounders out there, Berkshire may be the best. There are also companies like Markel and Fairfax Financial.
Minimizing taxes with ETFs
If single stocks don’t do it for you, ETFs would be an excellent way to play this trend. Accumulation share classes for index funds means that all fund income will be reinvested back into the fund, with no charge to reinvest. The income share class pays out the income. The added advantage to this is that you’ll be able to benefit from the compounding power of dividends without doing any extra work. And at the same time, you should be able to lower your tax bill, creating a capital gains asset that slowly grows over time without and stock specific risk.
Investors can only control a few select factors when they’re investing. Controlling costs is vital if you want to maximize returns over the long term. It might be an afterthought for most investors but lowering your tax obligations is one of the easiest ways to boost returns. That 20% saved might not seem like much, but over the longer term, this little change can make a big difference.
Disclosure: the author owns no stock mentioned.
