Tuesday, June 12, 2007

No level playing field for individual investors aiming for capital gains

Last night I began re-reading CAPITAL IDEAS by Peter Bernstein and suddenly he gave away an important clue about why individual investors such as you and I are at a disadvantage when it comes to trying to beat the stock market.

He mentioned how much the market's volume has gone from being transactions by individual investors to transactions by funds - pension funds, mutual funds, endowment funds and charitable funds. And he casually mentioned how these were tax-free -- that is, free of all capital gains taxes. He repeated this again a page or two later.

The proverbial light bulb went off over my head. No capital gains taxes! Say what?

I don't know about you, but I never knew that before. To tell the truth, I'd never thought about these funds paying capital gains taxes. I just assumed they did.

I can understand why the government allows them to sell securities without paying capital gains taxes, but it still puts you and I at a significant disadvantage relative to these institutions, when you and I try to compete as stock pickers.

We have to pay capital gains taxes. That's a significant drag on the long term performance of any person buying and selling stock. It's why Warren Buffett's favorite holding period is "forever."

So by not having to pay it, these institutions are making decisions free of a major constraint that we face.

This is a major factor in the stock market -- and nobody's talking or writing about it.

So it's one more good reason why we should be investing for income, not capital gains. Because if we play the buy stocks now so they'll go up and we sell them at a profit game, we're competing against major institutions and fund managers who not only have tremendously more resources (including their time) than we have -- but they don't have to pay capital gains taxes, as we do.

Don't pay capital gains taxes, yet enjoy a cash return from your investments -- buy securities for income, and never sell them.