The Little Book of Common Sense Investing, Updated and Revised

Chapter EightTaxes Are Costs, Too

Don’t Pay Uncle Sam Any More Than You Should.

WE STILL AREN’T THROUGH with these relentless rules of humble arithmetic, the logical, inevitable, and unyielding long-term penalties assessed against stock market participants by investment expenses, the powerful impact of inflation, counterproductive investor behavior, and fund industry promotion of untested and “hot” mutual funds. These practices have slashed the capital accumulated by mutual fund investors. The index fund has provided excellent protection from the penalty of nearly all of these hidden costs. (Of course, the index fund’s real returns were not exempt from the ravages of inflation, which impact all investments equally.)

But there is yet another cost—too often ignored—that slashes even further the net returns that investors actually receive. I’m referring to taxes—federal, state, and local income taxes.¹ And here again, the index fund garners a substantial edge. The fact is that most managed mutual funds are astonishingly tax-inefficient Why? Because of the short-term focus of their portfolio managers, who too often are frenetic traders of the stocks in the portfolios that they supervise.

Managed mutual funds are astonishingly tax-inefficient.

The portfolio turnover of the average actively managed equity fund, including both purchases and sales, now comes to 78 percent per year. (The “traditional” turnover rate—which includes only the lesser of purchases or sales—is 39 percent.) ...