Imagine the following: You, the investor, believe you have an uncanny skill at picking stocks. You set up an online trading account and begin to buy and sell. As it turns out, you are quite good. You pour more money into your brokerage account and up your trading. After the first year, you look at your results: You have trounced the indexes. You snicker at your friends who invest passively in low-cost, low-turnover indexes.
You keep at it, year after year trouncing the Standard & Poor's 500-stock index. Over the long haul, you beat that benchmark substantially — in some years, you gain 30, 40, even 50 percent more than the S&P gains.
Over 24 years, you tally up gains and losses. The markets are up, on average, about 9.3 percent annually. You, the World's Greatest Trader, do much better — 40 percent better. That's better than most of today's hedge funds.
How did you do vs. your friends the passive indexers? About the same.
How is that possible? You trounced the indexes, you crushed the benchmarks, you are the greatest! How could this happen?
In a word, taxes. Traders pay a healthy tax of 30 percent or more on short-term capital gains. Effectively, you lose the benefits of compounding on one-third of those gains. Over time, this has a tremendous impact on your net returns.
Imagine that 24 years ago, your best friend invested $10,000 in the S&P 500 and held on through last year. He would have amassed $76,266. That number includes taxes paid annually on whatever dividends came his way at the highest taxable bracket.
Compare that with you, the World's Greatest Trader. Had you put that $10,000 into a trading account that same year and annually crushed the S&P 500 by 400 basis points, you would have amassed an after-tax return of only $69,197.
In other words, your passive-index buddy would have beaten you, the World's Greatest Trader, by about 10 percent. (Note that I am ignoring all of your trading costs.)
Now imagine the same sort of trading account; only this time, add in a retail stockbroker's commission. The outcome is utterly absurd.
The number-crunching for this analysis comes from Michael Batnick, whose blog is called the Irrelevant Investor. He is also, not coincidentally, my firm's director of research. When he first ran the numbers, we tried hard to pick holes in it. Sure, it's well established that passive beats active most of the time before taxes. Once we added in the big slice of the pie to Uncle Sam, active trading began to look downright silly. Makes you wonder why anyone would engage in such a ridiculous hobby!
Mutual firms and hedge funds have a huge advantage that you, the individual investor, do not. They are a business. As such, they pay taxes on their total net gains. Losing trades offset winning trades dollar for dollar. Their investors also pay taxes on their net returns (not on each winning trade). This is why they can get away with this sort of active trading. Their tax bite is much, much smaller.
As an individual investor, you get to carry forward just $3,000 a year in losses to offset those gains. Sizable portfolios in the 2008-2009 crash lost millions. Folks who sold at the bottom in 2009 lost anywhere from 40 to 60 percent. They'd better watch their blood pressure if they want to carry those financial crisis losses forward for the next 150 years or so.
Barry Ritholtz is chief investment officer of Ritholtz Wealth Management. He runs a finance blog, the Big Picture.