To clearly demonstrate the advantage of buy and hold equities, I will posit the following situation. Ten years ago on November 23, in the year 2000 you had $10,000, which you wanted to invest in a quality Australian company. I was originally going to say you chose BHP (whose performance I might add was much better than the stock I chose), however, they have done several things like stock splits & de-mergers in the last 10 years, that make a retrospective calculation tricky.
I should comment that hindsight stock picking is easy, the selected stock is not relevant, it is the decision point we come to 10 years later that I seek to demonstrate.
So I settled on Woolworth’s (WOW), a nice stable company with a solid history & good prospects. You took your $10k and purchased 1298 shares ‘at market’ and got them for $7.70 ($9,994.60), I have left off brokerage, as I don’t think it relevant to the discussion. In any case, you signed up to the WOW DRP (dividend reinvestment plan), put the stock in the drawer and forgot about it.
Today, November 22, in the year 2010, you examine your WOW holdings and find that you own 1810 shares, worth $48,779.50 at today’s closing price of $26.95. This comprises:
1. Starting capital = $9,994.60
2. Re-invested dividends = $10,663.54 (512 shares @ average of $20.83) &
3. Capital gains = $28,151.36
Genius investment you say, well you could have sold the whole parcel for about $10k more in late 2007. By the way, the part of the investment you don’t see is the over $4k in franking credits you also received (an important factor I think is under-recognised by most investors).
In any case, the decision point is this. You believe that WOW are likely to perform at best marginally better than the market, however, you have discovered another share, XYZ – that you believe can outperform the market over the next 5 years by 3% per annum.
Should you sell now and invest? We’ll make these assumptions 3:
1. The market performs at its historic average over the last 30 years, by performing at 12.47% pa for the next 5 years
2. You are also correct about WOW performing only marginally better than the market, they maintain their historic 3.22% dividend return, with a 10% annual capital gain for a 13.22% total return (only 0.75% better than the market)
3. You are also correct about XYZ, over the next 5 years, they return a total of 15.47% pa including reinvested dividends (3% over market returns)
So what do we see on November 23, in the year 2015?
1. If you stayed in WOW, and returned 13.22% pa, our investment would be worth $90,751.35
2. If you sold your WOW & crystallised your $28,151.36, using the 50% capital gains tax discount, you paid tax of $5,348.76 (assuming a 38% tax rate) on your taxable gains of $14,075.68. You invested the after tax amount of $43,430.74 in XYZ and it was worth $89,154.46 after 5 years.
Well, despite our investment in XYZ annually returning 2.25% more (not an unimpressive effort) than WOW over the 5 years, our investment was still worth $1,596.89 less than if we did nothing. In fact, over a 5-year period, under the figures used, XYZ would have had to generate 15.88% (2.66% pa better than WOW) just to equal the performance of WOW over 5 years.
The lesson? Don’t change investments on a whim, because it seems clever. Unless you are virtually certain that an alternative investment is substantially better than your current one, there is a high likelihood that you are better to leave the ‘free leverage’ provided by your ‘unpaid tax’ on current investments. Tony Hansen 01/12/10.