The Investment Benefits of Compounding

You’ve heard that compounded returns are the eighth wonder of the world. But many people don’t realize just how important it is to let returns compound. It might be too late for you to achieve the really big numbers, but there probably are younger people in your life who would benefit from the knowledge. They should take a look at this blog post, and especially the charts in it.

Stocks happen to be a very tax efficient asset class if done right. An owner of a stock for more than a year pays “only” 20% at the highest current tax rate. Things are much less reasonable in other areas of the market… notably with taxable bonds where all income is taxed at the investor’s income tax rate. The chart below is an example of the impact for an investor assuming high yield bonds return the current yield to worst (5.5%) for the foreseeable future and that the returns are taxed at the top 39.6% tax bracket (5.5% return becomes a 3.3% return after taxes – and the taxes cannot be postponed for bonds in a taxable account). In this example, the impact of taxes on bonds is greater on a dollar per dollar basis than it is for stocks despite lower returns… in the stock example above, stocks returned 8% while in this example bonds returned 5.5%, but the variance moved from a $185 difference to a $232 difference.