Trading vs. Holding: The Taxes You Can Avoid

I want to showcase another impact of taxes by comparing two investment strategies. The “Buy & Hold” strategy involves selecting a broadly diversified portfolio and holding it for the long term. On the other hand, the “Pick & Pull” strategy focuses on identifying undervalued assets or those expected to outperform a broad market. The investor then sells when the timing feels right, realizes gains, pays capital gains taxes, and reinvests the proceeds into the next opportunity. Let’s see how taxes influence the outcome.

As a benchmark, assume a “Buy & Hold” investor purchases an asset that grows at 10% annually, holds it for 30 years, and then pays a 33.3% capital gains tax upon sale. The resulting annualized return, net of taxes, is 8.63%.

Now consider a “Pick & Pull” investor who turns over their portfolio every 5 years. Due to repeated taxation, this investor must generate an additional 2.08% in annual return over the full 30-year period just to break even with the “Buy & Hold” strategy. This gap exists purely because of the compounding impact of taxes.

The diagram below compares the two strategies. The horizontal axis represents turnover frequency (in years), while the lines show

(1) annualized return net of taxes, and

(2) the additional return required to match the “Buy & Hold” strategy. For the sake of this case, I have assumed a 10% annual return for the "Buy & Hold" strategy.

The following diagram illustrates the same concept under a lower capital gains tax rate of 20%.

Conclusion:

With a “Pick & Pull” strategy, you must:

• Do significantly more work and research

• Consistently outperform a broad market benchmark

• Overcome the drag created by repeated taxation

If you are actively selecting individual assets or attempting to time market cycles, this analysis is worth keeping in mind.

However, tax-advantaged investment accounts are more forgiving. In many cases, changes in investment positions do not trigger immediate taxation, allowing compounding to continue with less friction.