Investing is a great way to grow your wealth over time, but it comes with a silent partner – the United States government. For almost every dollar you earn, you eventually pay taxes. In a traditional IRA, you defer your tax obligation until it’s time to take Required Minimum Distributions. The distributions are then taxed as ordinary income. In a Roth IRA, you pay the taxes upfront, which is a great deal as you can then grow your assets tax free. You can pay off your silent partner right away.

For taxable vehicles, your partner takes a cut via capital gains tax, with rates varying depending on how long the asset was held and your total income. Taxable gains are only realized when selling an asset, so for some investors it’s tempting to simply not sell, as the value of assets included in the owner’s estate is adjusted to fair market value as of the owner’s date of death. This resets the cost basis, eliminating gains on the security. Assets held in trust or in other planning vehicles have different approaches to measuring gain or loss, but the point for this discussion is that they will have recognition of capital gains or losses when assets are sold.

Not selling appreciated assets can lead to a couple of problems. If a stock price goes up faster than prices of other holdings, that holding becomes a larger portion of the portfolio. This can lead to concentration risk, i.e. the portfolio is too exposed to only one name. If multiple stocks appreciate, the overall equity allocation could become well above the target making the portfolio riskier than is comfortable. To avoid a concentrated position or too much equity exposure, a reduction in overweight positions is a prudent investment approach, even if it triggers capital gains.

A standard response to these concerns is comfort with the holdings – believing they will continue to be winners for the foreseeable future, or at the very least stay in business. Being comfortable with a stock and firmly believing it will stay in business is not the best way to grow your wealth over time. For example, a portfolio consisting of four of the blue-chip names in 1999 may have consisted of Cisco Systems (CSCO), General Electric (GE), International Business Machines (IBM) and Pfizer (PFE) (keeping to 4 names for simplicity). All these companies have stayed in business and navigated the changing landscape over the last 24 years.

CSCO’s switches and routers are still used in modern IT architecture, but growth slowed significantly once the initial network build-out happened in the early 2000s. PFE has had successful drug launches and was at the forefront of COVID vaccines. GE has continued to reshape itself as an industrial conglomerate, e.g. in the last 10 years moving away from financing. IBM is also adjusting to the current cloud environment. But none of the stocks have performed well over the last two plus decades. CSCO, GE and PFE all trade at a lower price than they did at the end of 1999. IBM is the big winner, seeing its price increase from $103 to $164 (59% increase). On the other hand, the S&P 500 Index has gone from 1469 to 4770, a 225% increase.

If we take the total return (assuming re-invested dividends), the average annualized return is 1.3% for CSCO, -1.2% for GE, 4.5% for IBM and 3.2% for PFE, for an overall average return of just under 2%. That compares to the S&P 500 total return of 7%. If an investor held onto these positions to avoid any capital gains, they would have returned under 2% (even less after dividend taxes). On the other hand, an S&P 500 investor would have taken the 7% return and paid some capital gains. Assuming a 20% turnover in the portfolio, a 35% gain on all sales and a 20% tax rate, capital gains cost the investor about 1.4% of the return, knocking the 7% return to 5.6% (again, not accounting for dividends). The 5.6% after tax return is almost three times that return of the buy, hold, and avoid taxes strategy.

This example illustrates that portfolio management decisions are about growing wealth over the long term. No investor wants to pay taxes, but once it’s accepted that the government is your partner, the best investment decisions can be made.