01/06/2013 The Invisible Hand

Small Portfolio	XLF & IAU	20.00%
Sector	XLF	32.67%
Secular	IAU	7.33%
Large Portfolio	Date	Return	Days
RIMM	7/16/2012	64.83%	173
SEAC	9/25/2012	24.24%	102
CAJ	9/25/2012	14.10%	102
DDAIF	9/25/2012	7.90%	102
CFI	10/31/2012	38.80%	66
RE	11/26/2012	7.79%	40
CGX	12/12/2012	5.89%	24
PAAS	12/20/2012	3.58%	16
OKE	12/28/2012	5.24%	8
STRA	12/31/2012	10.01%	5
S&P	Annualized	5.54%
Small Portfolio	Annualized	12.06%
Sector Model	Annualized	19.30%
Large Portfolio	Annualized	30.23%

 

Rotation: selling STRA; buying BWS (Brown Shoe Company).

I’ll take 10% in a week.  Why not?

In any case, I’ll start with a correction from the other day.  One of the advantages of having a blog is that people can let you know when you are wrong.  Turns out that the dividend taxes didn’t go up to 43.80% (as Obama wanted), but rather to 23.80%.  So, my Effective Tax Rate numbers were off.  The correct numbers are:

Years	Growth Taxes	Annualized	Dividend Taxes	Effective Tax Rate
0	43.80%	43.80%	0.62%	43.80%
1	23.80%	23.80%	0.62%	24.42%
2	23.80%	11.27%	0.62%	11.88%
3	23.80%	7.38%	0.62%	7.99%
4	23.80%	5.48%	0.62%	6.10%
5	23.80%	4.36%	0.62%	4.98%
6	23.80%	3.62%	0.62%	4.24%
7	23.80%	3.10%	0.62%	3.72%
8	23.80%	2.70%	0.62%	3.32%
9	23.80%	2.40%	0.62%	3.02%
10	23.80%	2.16%	0.62%	2.78%
11	23.80%	1.96%	0.62%	2.58%
12	23.80%	1.80%	0.62%	2.41%
13	23.80%	1.66%	0.62%	2.27%
14	23.80%	1.54%	0.62%	2.16%
15	23.80%	1.43%	0.62%	2.05%
16	23.80%	1.34%	0.62%	1.96%
17	23.80%	1.26%	0.62%	1.88%
18	23.80%	1.19%	0.62%	1.81%
19	23.80%	1.13%	0.62%	1.75%
20	23.80%	1.07%	0.62%	1.69%

 

The 0.62% for Dividend taxes is the percent from your total stock holdings, assuming an average Dividend payout of 2.6%.  In other words, 23.8% (tax rate) on 2.6% (typical annual dividend) is about 0.62% of your total holdings.

I appreciate the tip I got so I could correct my numbers.

Now, I do want to reconcile two previous blogs, because I’d like to offer an idea of how the AGGREGATE of investor behavior can change even though the INDIVIDUAL investor may not.

You may recall:

http://market-mousetrap.blogspot.com/2012/11/11172012-how-to-really-soak-rich.html

On that post I calculated the optimal Capital Gains tax rate to maximize government tax revenue, assuming that investor behavior stayed the same regardless of the tax rate.

Then a few days ago:

http://market-mousetrap.blogspot.com/2013/01/01042013-compounding-and-taxes.html

Here I suggested that aggregate investor behavior would in fact change, and that the average holding period for stocks would lengthen now that Capital Gains rates have been raised.

My idea is that the aggregate behavior would change even though each individual’s behavior may not.

Here’s the idea:

Let’s assume that the average holding period on stocks is 9 months.  The average investor will pay short term capital gains.

But averages are based on a spectrum of investors who each hold stocks for different periods of time.  Women, for instance, typically hold stocks for longer than men – which is why the average woman does better than the average man in the market.

So, let’s simplify this and reduce the entire market to just two people, Mr. and Mrs. Jones.  When they got married, Mr. Jones had ten times as much money as Mrs. Jones.  He normally holds stocks for 3 months and his wife normally holds stocks for 6 years.  On AVERAGE the married couple is paying at a short term capital gains rate.

Now, let’s assume that they each make 15% a year in the stock market, but Mr. Jones pays 43.80% in taxes, while Mrs. Jones only pays 4.24% per year in taxes, because she is paying at a 23.80% RATE but only after six years of compounding, giving her a 4.24% annualized tax rate (see the table above).

They invest that money for their entire careers and this is what happens:

Years	Mr. Jones	Mrs. Jones	Average months held	Average Tax Rate
	(3 months)	(6 years)	(per dollar)	His 43.8% and her 4.24%
1	$100,000.00	$10,000.00	9	40.20%
2	$108,430.00	$11,436.40	10	40.03%
3	$117,570.65	$13,079.12	10	39.84%
4	$127,481.85	$14,957.81	10	39.65%
5	$138,228.58	$17,106.35	11	39.44%
6	$149,881.24	$19,563.51	11	39.23%
7	$162,516.23	$22,373.61	11	39.01%
8	$176,216.35	$25,587.35	12	38.78%
9	$191,071.39	$29,262.72	12	38.55%
10	$207,178.71	$33,466.02	13	38.30%
11	$224,643.87	$38,273.08	13	38.04%
12	$243,581.35	$43,770.62	14	37.77%
13	$264,115.26	$50,057.83	14	37.50%
14	$286,380.18	$57,248.14	14	37.21%
15	$310,522.02	$65,471.26	15	36.91%
16	$336,699.03	$74,875.55	16	36.60%
17	$365,082.76	$85,630.68	16	36.28%
18	$395,859.24	$97,930.67	17	35.95%
19	$429,230.17	$111,997.43	17	35.61%
20	$465,414.27	$128,084.74	18	35.26%
21	$504,648.70	$146,482.84	19	34.90%
22	$547,190.58	$167,523.63	19	34.53%
23	$593,318.75	$191,586.72	20	34.14%
24	$643,335.52	$219,106.24	21	33.75%
25	$697,568.70	$250,578.66	21	33.34%
26	$756,373.74	$286,571.78	22	32.93%
27	$820,136.05	$327,734.95	23	32.51%
28	$889,273.52	$374,810.80	23	32.07%
29	$964,239.28	$428,648.62	24	31.63%
30	$1,045,524.65	$490,219.71	25	31.17%
31	$1,133,662.38	$560,634.87	26	30.71%
32	$1,229,230.11	$641,164.46	27	30.24%
33	$1,332,854.21	$733,261.33	27	29.76%
34	$1,445,213.82	$838,586.98	28	29.27%
35	$1,567,045.35	$959,041.62	29	28.78%
36	$1,699,147.27	$1,096,798.35	30	28.28%
37	$1,842,385.38	$1,254,342.47	31	27.78%
38	$1,997,698.47	$1,434,516.22	32	27.27%
39	$2,166,104.45	$1,640,570.13	33	26.75%
40	$2,348,707.06	$1,876,221.63	34	26.23%
41	$2,546,703.06	$2,145,722.10	35	25.71%
42	$2,761,390.13	$2,453,933.62	35	25.19%
43	$2,994,175.32	$2,806,416.65	36	24.66%
44	$3,246,584.30	$3,209,530.33	37	24.13%
45	$3,520,271.36	$3,670,547.27	38	23.61%

 

Three things happen here.  First, Mrs. Jones has more money when they retire.

Second, the AVERAGE HOLDING PERIOD FOR EACH DOLLAR goes up from 9 months to 38 months, even though they never changed their individual behavior.

Third, the average tax RATE they pay as a couple goes down every year, from 40.20% to 23.61%.

So, then, this is my thesis: INDIVIDUAL behavior does not have to change in order for MARKET behavior to change.  The market is measured in dollars, not people.

Liberals like to assume that the market is a zero sum game, and Conservatives like to assume that investors will rationally calculate what is in their best interest.

I think they are both wrong.

Liberals are probably right that individuals don’t pay enough attention to get out of the tax man’s way.

But Conservatives are probably right that aggregate behavior will change when tax rates change.  By raising rates, short term investors will be punished more than long term investors, and the money in the market will shift even faster toward longer and longer holding periods.

Some months ago Paul Krugman pointed out on his own blog that the market doesn’t seem to be affected by changes in capital gains rates.  What he failed to account for is the fact that the market ADAPTS to these different rates by changing aggregate behavior, even though individual behavior might stay the same.

The market functions in a Darwinian process, shifting money toward those who by accident or plan adopt trading strategies that are better fit for the environment the government has altered.  Those that do not adapt will see their retirement accounts go extinct.

The purpose of this blog is to study such accidents so that we can learn from other people’s mistakes rather than our own.

Some animals accidentally grow fangs.

Other animals use their brains to create swords.

Either way works.

Tim