Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition

CHAPTER 5

Many a Slip: Trading, Execution, and Taxes

As investors consider different investment strategies, they have to take into account two important factors that can determine whether these strategies pay off—trading costs and taxes. It costs to trade, and some strategies create larger trading costs than others. The costs of trading clearly impose a drag on the performance of all active investors and can turn otherwise winning portfolios into losing portfolios. As we debate the extent of these costs, we need to get a measure of what the costs are, how they vary across investment strategies, and how investors can minimize these costs. In this chapter, we take an expansive view of trading costs and argue that the brokerage cost is only one and often the smallest component of trading costs. We also look at the trading costs associated with holding real assets (such as real estate) and nontraded investments (like equity in a private business). In addition, we discuss the trade-off between trading costs and trading speed.

There is a second equally important element in investment success. Investors get to take home after-tax returns and not before-tax returns. Thus, strategies that perform well before taxes may be money losers after taxes. Taxes are particularly difficult to deal with, partly because they can vary across investors and across investments for the same investor, and partly because the tax code itself changes over time, often in unpredictable ways. We will consider ...