The hidden tax in your portfolio

Taxes eat your portfolio.

The tax I’m talking about has nothing to do with your income. The IRS doesn’t take it.

We’re talking about volatility tax. Volatility tax is not common knowledge. Volatility tax only shows up through portfolio drawdowns.

The worst part of volatility tax is that it’s a math exercise. Sorry. I hope that doesn’t scare you away from reading on. It’s a really important concept.

Here is how the tax is assessed:

Starting with $100 and then falling to $50 is a 50% loss. To get back to $100 you need to gain $50. Gaining $50 off of a $50 starting balance is a 100% gain.

The example above is a cute math trick.

In real life, there are also taxes, expenses, additions/withdrawals, and inflation that impacts your portfolio. In other words… in real life, it’s much worse.

How do you reduce volatility tax?

Limit your losses then you reduce your volatility tax.

A portfolio used for cash flow cannot care about average returns.

If you search the average return of the S&P you will see it’s around 10%. The historical average of US treasury bonds ranges from 4-6%.

Focusing on average returns means you should only own the S&P 500. Adding bonds basically guarantees a lower average return.

Reducing volatility is typically promoted to help you sleep at night. There is truth to that point. However, it suggests you can’t handle adversity. If you’re reading a blog like this, you can handle adversity.

The real power of less volatility is driven by compound math. This is magnified when you begin taking withdrawals. It’s proven through the sequence of returns risk research.

Adding bonds to a stock portfolio is the conventional approach to managing volatility. It might not be the optimal solution. We will get into specific strategies that reduce volatility tax later.

For now, it’s as simple as this… reduce your losses to pay less volatility tax.

A real-life example of volatility tax

The 2000 dot com bubble is a well-known market top. The two years before the top generated outsized returns.

Retirement starting in January 1998 would receive over 28% and 21% in the first two years from the S&P 500. Then receive -9%, – 12%, and -22% over the next three years.

From January 1998 to December 2020 the average return for the S&P 500 was 9.53%. During that same time frame, a “balanced portfolio” averaged 7.74% (i.e. 60% S&P 500 and 40% US Intermediate Treasury… aka 60/40).

The S&P 500 averaged 1.55% more than the balanced portfolio. It also outperformed 15 out of 23 years.

How much would you have in December 2020 if you started with $1,000,000?

• If you took ZERO withdrawals
  • 100% S&P 500: $5,838,250
  • 60%/40% Stocks/Bonds: $5,079,473
    • 100% stocks beat 60%/40% by: $758,777

• If you took $45,000 annual withdrawals plus annual inflation increases
  • 100% S&P 500: $1,534,756
  • 60%/40% Stocks/Bonds: $1,668,073
    • 100% stocks lost to 60%/40% by: $133,317

The higher average return prevailed when there were no withdrawals. The higher average return failed when there were withdrawals. What’s happening?

Investment returns compound. Current investment returns multiply on top of the previous amount.

You benefit from compound returns, not average returns.

The S&P 500 outperformed the balanced portfolio by a 1.55% average return. It only outperformed by a .65% compound return.

To obtain a 9.27% average return the investor had to pay 1.30% of volatility tax. To obtain a 7.72% average return this investor only had to pay a 0.40% volatility tax.

The reason the S&P 500 investor had such a low compound return is that they didn’t manage market risk. They accepted market risk by investing “in the market.”

When they weren’t taking withdrawals this was OK. When they were taking withdrawals it was devastating.

Volatility tax reduces the growth of your investments. Its cousin, sequence of returns risk, reduces your cash flow. Both are side effects of unmanaged market risk.

This is why risk management needs to be part of your investment process.

Benjamin Graham said it best:

“The essence of investment management is the management of risks,
not the management of returns. Well-managed portfolios start with this
precept.”

Benjamin Graham

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