A LOT OF INVESTMENT math focuses on how money grows over time. But as an attorney who’s worked with many clients hoping to retire in comfort, I find myself thinking more about risk—and how the math can work against us. Consider five sets of numbers:
Inflation’s toll: 0.98
Got cash? If you multiply that sum by 0.98, you’ll see your money’s purchasing power a year from now. This assumes 2% inflation, which is the Federal Reserve’s stated target. To be sure, inflation has averaged less than 2% over the past decade. But cumulatively, it has still totaled roughly 17%. An item that cost $10,000 in 2011 would cost $11,692.68 today. Think your wealth is safer sitting in cash? It isn’t.
Goodbye, marriage: 0.5
Half. That’s roughly what you’ll give up if you divorce. Just about any small-town family law attorney will tell you the annoying-but-true adage, “It’s cheaper to keep her.” Each state has its own laws that apply to the division of property in a divorce, but the number approaches 50% in many states. For instance, if you live in a community property state, the general rule of thumb is you give up 50% of commingled assets, regardless of who contributed what. While there are ways to hedge through pre- and post-nuptial agreements, divorce is a true wealth destroyer.
The taxman’s take: 0 to 0.2—or 0.1 to 0.37
Take the gain on any investment and multiply it by these numbers. The first two numbers tell you how much you might lose to federal taxes if you sell a winning investment that counts as a long-term capital gain, while the last two numbers are the potential tax hit if you have a short-term capital gain.
For couples with total taxable income of less than $80,800 in 2021, the long-term capital gains rate is 0%. Above that amount, the long-term capital gains rate is 15%, unless your taxable income exceeds $501,600, in which case it jumps to 20%. By contrast, short-term capital gains—which are triggered by selling winning investments owned for 365 days or less—are taxed at ordinary income tax rates, which means you’ll lose 10% to 37% of your gain to the taxman. Short-term capital gains are a killer of long-term wealth accumulation.
Those with lower incomes are less affected by the difference between short- and long-term capital gains. Suppose you’re married and your combined taxable income is just above $81,000. Your recent foray into GameStop may have resulted in a quick profit (though probably not), but your tax rate is going to be seven percentage points higher because you didn’t own the stock for more than a year.
The higher you go up the income spectrum, the more draconian this disparity gets. Those in the top tax bracket pay 17 percentage points more on their investment winners to Uncle Sam if they don’t wait 366 days to sell. Does that mean taxes should wag the investment dog? No, but most investors ought to care more than they do about the tax tab—and financial advisors often don’t care at all, as they merrily buy and sell investments in their clients’ portfolios.
Paying the help: 0.01 and 0.25
The fees paid to financial advisors have a negative compounding effect. Those fees are often around 1% a year—equal to multiplying your portfolio’s value by 0.01—but sometimes much higher. Paying 1% in fees over 40 years to an advisor trims a portfolio’s total gain by roughly 25%.
Investing recklessly: 0
Over the past year, many Americans have begun day trading and using leverage to boost their investment returns. If the market sells off, those who are extremely levered run the risk of losing all of their money. It’s a story that’s been repeated over and over again.
Anything multiplied by zero is zero. It goes without saying that it’s a lot harder to come back from zero than any other financial setback. Maybe that’s why Warren Buffett says, “Rule No. 1 is to never lose money. Rule No. 2 is to never forget rule No. 1.”
What’s the best solution to avoid the above killers of compounding? For starters, find a spouse whose value isn’t just in his or her earning power, but also in the incalculable love and support that he or she offers. Meanwhile, the rest of the unfortunate math outlined above can be avoided by doing one simple thing: Buy low-cost index funds and hold on through thick and thin. The math is simple—but following through is much harder.
John Goodell is general counsel for the Texas Veterans Commission. He has spent much of his career advocating for military and veterans on tax, estate planning and retirement issues. His biggest passion is spending time with his wife and kids. Follow John at HighGroundPlanning.com and on Twitter @HighGroundPlan, and check out his earlier articles.