I recently had the opportunity to pick up a free copy of the latest Motley Fool book, Million Dollar Portfolio. I’ve never spent much time looking at what the folks at Motley Fool do, though I know their focus is on stock investing. With that and the idea that I could provide my readers with a review of the book when I finished, I decided to go ahead and get it.
I’ve only just started reading Million Dollar Portfolio as part of my daily commute. It will probably take a little while to get all the way through, so you’ll have to wait for a the full review until then.
There is one little thing I need to comment on, however.
At the start of the third chapter, in classic investor book fashion, the authors attempt to demonstrate why a buy-and-hold approach beats a trading approach. Taxes and transaction costs are the noted culprits which make trading much less worthwhile than investing.
Here’s the problem, though.
The example they use is so completely erroneous as to be farcical.
A scenario is offered in which you can either invest $1000 in a stock which makes 7% per year, or you can use that $1000 to play one stock each year that makes 12% per annum. Transaction costs are $10 per side. Short-term capital gains taxes in the U.S. are 15%. Long-term capital gains taxes are not listed, but are said to be higher. The authors claim that the 7% option turns the initial into $6137, while the 12% option actually only gets you up to $3073 after all the transaction costs and taxes which come out along the way.
Seems like a pretty good argument for investing, doesn’t it?
It’s a complete crock!
The numbers don’t work out at all. All we have to do is look at where each portfolio is at after one year to see the error.
At the end of the first year the 7% portfolio is worth $1070 ($1000 x 7%). Actually, if we take out the $10 commission for buying that $1000 worth of stock the real value is $1060.
Where the 12% portfolio value is at in one year depends on the short-term capital gains tax rate. That year’s trade will make $120 ($1000 x 12%). We need to take out $20 for transaction fees, so that leaves a $100 profit. Now, if the tax rate is more than 40%, then the 12% portfolio ends up with a final value lower than than the 7% one. At 40% the two are the same. Any tax rate lower than that the 12% portfolio is the winner.
A little investigating indicates that the top end U.S. short-term capital gains rate is 35%. My calculations indicate that at such a rate the 12% portfolio would end up with a final value close to $9000. That’s considerably better than the $6137 the authors indicate would be the final value of the 7% portfolio (though my calculations put it somewhere closer to $6500).
On top of this funky math, they get even more ridiculous.
The Motley Fools cite a report from Charles Schwab which says that short-term traders need to make 21.2% more than the longer-term ones to offset the taxes. Somehow they translate this figure to mean it would take a 48% annual pre-tax return to better the 7% portfolio’s results. I really don’t know where they pulled that number from. It clearly, though, has no basis in reality.
I’m not arguing here against the overall contention that longer-term traders have lower transaction cost and capital gains hurdles to overcome. They most certainly do. Traders need to be pretty sure they are going to considerably exceed the returns they would expect to get from a buy-and-hold strategy in order to make trading worth their while. I just have really hard time respecting the conclusions put forward by someone who is so painfully off in constructing their arguments.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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