If you had to pick one investment for the next 10 years, any investment: crypto, Apple, gold, real estate, what would it be? What about the next 20 years? Or 40 years?

I’ve seen people on social media say they were picking a stock, one stock, for the next 10 years. Some of them have said it in a manner that makes it seem as if they’re being conservative. Like investing in Apple or Tesla is the conservative route.

That may seem conservative compared to people who speculate on SPACs and shitcoins but over long periods of time, this is an extremely high risk gamble. Sometimes those gambles do pay off. We often hear the story of loyal employees who accumulate company stock over decades of service and make a fortune. You may even know someone who has worked at a tech company or a start up who has received RSU’s (restricted stock units) and struck it rich. Or you may have heard of a friend of a friend who struck it rich holding Dogecoin or some other speculative investment. Those are all great, and if you were one of those people, even better for you, but when you have the perspective that comes with long term investing and you start to examine after tax returns, the wonders of long term diversified compounding remind you that patient money often beats out fast money in the real world.

Diversifying

We all know the boring case for diversification: it lowers your risk and most people don’t beat the market over the long run. Yawn. Yet to see the power of holding a diversified portfolio over the long term, it helps to strip away the fantasy from reality.

When someone buys 1 stock for the next 10 or 20 years, they usually aren’t hoping it will underperform the market or even match the market. If either of those were true they would just buy an index fund that matches the market return. Rather, what they are implicitly saying and what they are telling themselves is that they think this one stock will beat the market over the next 10 years. Does this happen? Yes it does. There are a number of stocks that beat the market over a decade. Apple is an example of that. They are not easy to pick but it can be done. Yet when you pick one stock, risk also increases with the time that you hold it and this is a risk that isn’t examined as often.

Earlier in the year, Warren Buffet in his annual letter to shareholders, tried to point out how the market can change dramatically over long periods of time. He showed the largest stocks globally by market capitalization in 1990 versus 2020 and all of them were different. I found an illustration that breaks down 40 years of market changes into 10 year periods of the largest companies by market cap to show how much things change.

From 1980 to 2000, Exxon Mobile was going strong but by 2021 it was no longer even in the top 10. 6 of the companies on top in 2021 didn’t even exist in the year 2000 and not one company, not one, stayed in the top 10 over the 41 year period examined. Even stalwarts like Exxon Mobile will go through changing demands for its products and face its own unique challenges, picking Exxon in 2000 alone would have been a losing bet over the next 20 years.

You may say to yourself, ok that’s fine but what I will do then is update my picks every 10 years. Most people don’t have this level of discipline but maybe you do it and can somehow beat the market. If you can, then great, you must be really wealthy by now and enjoy reading investing nerd blogs in your retirement.

However, if that single stock pick is in a taxable account, there is one more downside to picking that one stock and selling it every once in a while for a new investment: tax drag.

What is Tax Drag and Why Does it Matter?

Im many countries and here in the US, investors pay a lower rate for long term investments compared to short term investments. For simplicity’s sake let’s say the top rates for the two are 20% for long term gains and 35% for short term gains.

If taxes are paid when the stock is sold and the gain realized, something which could potentially change due to the current debate in Congress, the reduction in the after tax value has a compounding effect on future after tax returns over time. This is called the tax drag.

The tax drag increases with higher returns and longer investment horizons. To see its effect, you would have to calculate what is called the accrual equivalent return. This is the annualized return on your after tax proceeds after taxes have been paid.

It’s easiest to see the effect with an example. Let’s say you invest $10,000 today in an S&P 500 index and don’t sell it for 40 years. Let’s ignore taxable dividends for now. Assuming it grows at the historical long term rate of 10%, this will give you $452,593 after 40 years, $442,593 of which is taxable as a long term gain of 20%, meaning your after tax proceeds would be $364,074. Divide this figure by $10,000 and then annualize the after tax return and you come out with a 9.4% after tax return. This is an effective annual tax rate of 6%. Again, this phenomenon is the consequence of compounding math, which doesn’t always fit our linear conceptions.

On the other hand if you paid that long term gain annually, your after tax return will come out to 8% and if you get all your gains from short term gains at the highest rate, your after tax returns will be 6.5%.

What this means is that if you are trying to achieve the same after tax return through short term gains, you would actually need a pre-tax return over 40 years of 14.46%. Few investors have ever achieved gains like this over such a long period of time, which shows why picking stocks for a taxable account can be such a futile endeavor.

In the real world there are annual dividends which pay taxes annually. Yet even still, about half the long term return on stocks comes from capital gains which still means the tax drag will help you. This could equate to a return that is 0.7% annually higher than just paying the long term rate of 20% every year. Over 40 years that gives you 32% more than you would have otherwise.

What Are the Consequences?

The results of tax drag show that the best thing you can do to achieve the highest after tax return in a portfolio is to never sell. Ok, maybe never selling is not realistic but there should be a portion of your investment which is taxable that if you can, you don’t sell for decades on end in order to maximize tax drag working in your favor.

If I had to pick one investment that would achieve the highest deferred tax return over a 40 year period I would definitely choose equities and I would definitely make it global so that it doesn’t falter if the US falls behind in growth. That leaves us with a pretty simple choice: the global equity portfolio. This is a global portfolio of all the largest companies in the world held in proportion to their market cap. Vanguard offers such a portfolio which tracks the MSCI World Index that goes by the ticker VT. I hold this as an ETF as a core part of my portfolio and plan to not sell it until I am old for the very reasons I have described here.

As I described, the real world is a bit different than the hypothetical example I laid out. This ETF does pay dividends which are taxable now. Yet if you are being mindful of your taxes you can offset these dividends with any losses you have elsewhere. I hold an emerging market ETF which has been volatile lately and I realized a loss recently in order to offset gains and dividends in other parts of my portfolio. The point is that tax management of your portfolio can create different incentives and behaviors in terms of the way in which you approach your investments. In contrast to a taxable portfolio, a traditional IRA will have an incentive to maximize gains at all costs as the taxes are deferred until retirement.

Tax drag for me means that although there is tactical investing I do in particular markets or even in particular stocks, I always keep the core of my taxable portfolio as globally diversified equities which I never consider selling. It’s just another way that the boring ol’ index returns can produce fantastic results.

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