The Taxable Investor's Manifesto

CHAPTER ONETaxable Investors Need to Think Differently

What makes a good investment? It's such a simple question, but not an easy one to answer. We never know in advance whether an investment will succeed. By their very nature, investments involve uncertainty. Nevertheless, one can evaluate proactively whether something is a good investment. To me, a good investment has more upside potential than downside risk; it's asymmetric. The investment becomes even more attractive when its upside can compound for a long time; it has high potential magnitude. A third valuable attribute is a favorable probability of success; 30% odds of doubling one's money is a lot better than 10% odds of doing so.

Another important characteristic that drives investment attractiveness is the percentage of the profit from a successful investment that the investor actually keeps, profit retention. Profit retention is different than asymmetry, magnitude, and probabilities because taxable and tax-exempt investors operate with different rules. A tax-exempt investor – like an endowment, foundation, or retirement plan – may keep 90% or more of the profits from a high-yield bond fund each year, and it can reinvest the entire 90%. The other 10% or so goes to the fund manager in the form of fees. On the other hand, a taxable investor based in California or New York earns and can reinvest maybe 50% of the profits because, in addition to paying the investment manager, the taxable investor must also pay taxes on income ...