Profit Potential

“…in this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin, October 24, 1788

Taxes must be considered when estimating the profitability of any market timing system.  Successful timing requires occasional to frequent selling, and selling means taxes on capital gains.  Market timing has to beat buy-and-hold, and the taxes!

Everyone’s tax situation is different, so we present here back-tested results of our market timing system with the following tax treatments:

Retirement Account – Grows Tax Free, Gains Taxed at 15% Once at Withdraw

Brokerage Account – Growth Taxed at 35% Annually, No Additional Taxes at Withdraw

Buy-and-Hold – Grows Tax Free, Gains Taxed at 15% Once at Withdraw

We assume no credit for capital loss carryover, 0% interest on cash balances, no brokerage fees and that taxes are paid from the profits of the accounts.  Negative growth is not taxed.  In the USA, short term capital gains are taxed as normal income (top bracket is 35%) and long-term capital gains are taxed at 15%.  For simplicity we have assumed these rates were unchanged and uniform historically.  Roth retirement accounts have no tax at withdraw but we omit this from the graphs because the difference is barely noticeable on the logarithmic y-axis.

The difference between green lines (retirement account) and blue lines (brokerage accounts) is from the taxes.  As you evaluate any market timing system, be sure to factor the tax implications.  A lot of our competitors show their leveraged, untaxed result (green line) versus unleveraged buy-and-hold without discussing tax implications.  If we did that, we would show only the 3x Leverage graph below with the green and solid-black lines.

Notable Observations:

  • As the leverage increased the performance for the brokerage and retirement accounts were superior.  Volatility increased with leverage, but our timing system was less volatile than buy-and-hold with the same leverage.  The market timing strategies were not free of losses, but the losses were less severe than buy-and-hold.
  • Without leverage, the compounding short-term capital gains tax nullified the benefit of market timing in the brokerage account, but there was still benefit in the retirement account.
  • On the 2x and 3x leverage graphs the dotted lines display buy-and-hold with the same leverage.  This fairly shows how much of the performance was from leverage, and how much was from our timing strategy.
  • There were years where buy-and-hold grew more than market timing, but over multiple years the market timing strategy eventually performed better and mitigated the downward swings when the market declined.

Tabular Results:

This table shows values from the graphs, omitting leveraged buy-and-hold (dotted lines).  With the stated assumptions, $1 invested at the end of 1985 would have grown to the amounts shown in the table, measured at the end of each calendar year. To estimate what your performance would have been, you can multiply the table value times the amount you could have invested.  For example, $1000 invested at the end of 1985 would have grown to $588,230 by the end of 2010 using 3x leverage in a retirement account.

Your actual performance will vary depending on how much you invest, your specific tax situation, the fees your broker charges and interest they offer on cash balances, and your use of retirement and brokerage accounts.  Past performance is not a guarantee of future returns.  All investing involves risk including the potential for losses.  The information on this page is for planning purposes and should not be construed as specific advice regarding taxes.

Capital Gains Tax Rates:

The long-term capital gains tax rate has been 15% in the United States from 2003 for most tax brackets.  The analysis on this page uses the 15% rate, although long-term capital gains for higher-income taxpayers jumped to 23.8% on 1/1/2013.  This is the 20% top bracket rate plus the new 3.8% Surtax on Investment Income levied on individuals making more than $200,000 a year, or couples with $250,000 or more.

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