How’d the Market Do? That’s Harder To Answer Than You Think
In taxable investing, your after-tax return—the amount you “take home”—is what’s important. Yet far too many investors focus on market performance. Let’s look at the difference.
To understand after-tax performance, it’s helpful start by examining your returns with dividends after adjusting for inflation—this is the closest valuation of your “real” return prior to taxes.
Your after-tax return depends heavily on how and when you make a withdrawal from your investments. One reasonable way of estimating your after-tax return is by looking at taxes on dividends
In this article, we showcase how you can estimate after-tax returns for just one holding. Keep in mind it gets much more complicated for a realistic portfolio scenario of many holdings with many cashflows.
Bill Gates once said, “You can achieve incredible progress if you set a clear goal and find a measure that will drive progress toward that goal.”
So true! It’s something we as investors should pay more attention to. Investing, for almost all of us, is about working toward some goal. Which means we have to be able to measure our progress toward that goal with precision.
One step in the process is measuring how the stock market has performed. How have your investments done? It sounds like an easy question, and it should be. But there are a few pieces of nuance to this puzzle that can throw investors off.
Let’s look at the S&P 500 (SPY) over the last 25 years. It’s gone up about 6.5-fold during that time. This is usually what people cite when talking about market performance:
But the S&P 500 index pays a dividend. Dividends might seem small and can be easy to ignore, but because of how strong the magic of compounding is they can make an enormous difference over time.
Here’s the same chart but with a additional form of measurement — S&P 500 with reinvested dividends:
We can go a layer deeper. Inflation erodes purchasing power over time, so $1 today isn’t worth as much as the $1 you invested years ago. To measure how the purchasing power of your investments has grown over time, we have to look at total returns minus annual inflation. That offers a whole new way to measure returns:
And we can even take this a step further.
Investment gains earned in a non-retirement account are generally taxed. When an investment pays a dividend, those payments are taxed, even if they’re reinvested. Here’s what happens when you factor in dividend taxes:
Source: Bloomberg. Assumptions on dividend taxation include a long-term gains rate of 22%, and short-term gains rate of 34%, a federal income tax bracket of 28%, and a state income tax of 0.9%. This simulation of taxation does not account for changes in tax rules for dividends over the period.
Add all this up, and you get wild differences in how you can answer the question, “What’d the market do?”
|Compound average annual return, 1993-2017||$1 in 1993 turned into by 2017|
|S&P 500 with dividends||9.7%||$10|
|S&P 500 with dividends after inflation||7.4%||$5.9|
|S&P 500 with dividends after inflation and dividends taxed||6.8%||$5.2|
Source: Bloomberg, reflective of dataset for figures above.
There are a few big takeaways from this.
- The most complete measure of returns—with dividends, after inflation, adjusted for taxes—is the most relevant when measuring progress toward your goals, because it offers the most honest look at how market returns have made you better off. It takes some work to calculate this number. The Federal Reserve publishes inflation data. Taxes vary by individual. But going through the effort to add up how you’ve truly done annually is vital to understanding how much progress you’re making toward achieving your goals.
- Taxes can be one of the biggest anchors to long-term compounded returns. The good news is that unlike inflation or market returns, they can be relatively in your control. Trading in and out of the market, particularly under the strategy of “taking a little money off the table,” might feel good in the short run but cost a fortune over the years. Compounding works by earning returns on your past returns. Paying taxes puts the brakes on that process, affecting your wealth not just in the year you pay taxes, but for years down the road as your money compounds off a smaller amount. Check out this article on how to think about market volatility, and you may become more comfortable riding out the market’s ups and downs rather than trying to strategically jump in and out.
- Compounding is not intuitive, so adding or subtracting a small amount from annual returns snowballs into something truly meaningful over time. It all depends on how you measure it. Those numbers are a universe apart, yet they grew out of fairly small changes in annual returns. I can’t help but look at these charts and both be humbled by the power of compounded and reminded of how important seemingly small things like fees, taxes, and inflation can be over time.
“This may seem basic,” Bill Gates said about measuring, “but it is amazing how often it is not done and how hard it is to get right.”
It’s the same in investing. Take the time to add up how you’ve truly done as an investor. The difference between how you did and how you think you did can be so huge you might totally change your perspective.
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