174 THE WARREN BUFFETT WAY
- It works to reduce transaction costs.This is one of those com-
monsense dynamics that is so obvious it is easily overlooked.
Every time you buy or sell, you trigger brokerage costs that
lower your net returns. - It increases aftertax returns.When you sell a stock at a prof it,
you will be hit with capital gain taxes, eating into your prof it.
The solution: Leave it be. If you leave the gain in place (this is
referred to as unrealized gain), your money compounds more
forcefully. Overall, investors have too often underestimated the
enormous value of this unrealized gain—what Buffett calls an
“interest-free loan from the Treasury.”
To make his point, Buffett asks us to imagine what happens if you
buy a $1 investment that doubles in price each year. If you sell the in-
vestment at the end of the f irst year, you would have a net gain of $.66
(assuming you’re in the 34 percent tax bracket). Now you reinvest the
$1.66, and it doubles in value by year-end. If the investment continues
to double each year, and you continue to sell, pay the tax, and reinvest
the proceeds, at the end of twenty years you would have a net gain of
$25,200 after paying taxes of $13,000. If, on the other hand, you pur-
chased a $1 investment that doubled each year and neversold it until the
end of twenty years, you would gain $692,000 after paying taxes of ap-
proximately $356,000.
The best strategy for achieving high aftertax returns is to keep your
average portfolio turnover ratio somewhere between 0 and 20 percent.
Two strategies lend themselves best to low turnover rates. One is to
stick with an index mutual fund; they are low turnover by def inition.
Those who prefer a more active style of investing will turn to the sec-
ond strategy: a focus portfolio.
THE CHALLENGE OF FOCUS INVESTING
My goal so far has been to lay out the argument for adopting the focus
investing approach that Warren Buffett uses with such great success. I
would be doing you less than full service if I did not also make it plain
that an unavoidable consequence of this approach is heightened volatil-
ity. When your portfolio is focused on just a few companies, a price