Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor

by Jeremy C. Miller

Consider two stocks, each compounding annually at 15% for 30 years (we’ll assume everyone’s capital gains rate is 35% to make our calculations easier). The investor who jumps back and forth between the two stocks each year will also have their gains taxed each year; the 15% pretax rate will slip down to 9.75% after-tax: [15% x (1 −tax rate) = 9.75%]; $10,000 invested today will be worth $150,000 in 30 years at this rate. Not bad. However, if the investor instead holds just one stock for all 30 years and gets taxed just once at the end, they get the same pretax rate of 15% but the after-tax rate improves to 13.3%. The same $10,000 will compound at an extra 3.55% and will ultimately produce 2.5 times as many after-tax dollars after 30 years. The deferral of taxes provides a form of financial leverage that allows the second investor to control more assets for longer. When each year’s gains are taxed annually, there is no deferral, and thus no benefit from leverage. That’s what makes DTLs so attractive.