Financial Effectiveness Repository

Gunnar_Zarncke

Follow-Up to: A Guide to Rational Investing Financial Planning Sequence (defunct) The Rational Investor

What are your recommendations and ideas about financial effectiveness?

This post is created in response to a comment on this Altruistic Effectiveness post and thus may have a slight focus on EA. But it is nonetheless meant as a general request for financial effectiveness information (effectiveness as in return on invested time mostly). I think this could accumulate a lot of advice and become part of the Repository Repository (which surprisingly has not much advice of this kind yet).

I seed this with a few posts about this found on LessWrong in the comments. What other posts and links about financial effectiveness do you know of?

Rules:

Each comment should name a single recommendation.
You should give the effectiveness in percent per period or absolute if possible.
Advice should be backed by evidence as usual.

General Advice (from Guide to Rational Investing):

Capital markets have created enormous amounts of wealth for the world and reward disciplined, long-term investors for their contribution to the productive capacity of the economy. Most individuals would do well to invest most of their wealth in the capital market assets, particularly equities. Most investors, however, consistently make poor investment decisions as a result of a poor theoretical understanding of financial markets as well as cognitive and emotional biases, leading to inferior investment returns and inefficient allocation of capital. Using an empirically rigorous approach, a rational investor may reasonably expect to exploit inefficiencies in the market and earn excess returns in so doing.

So what are your recommendations? You may give advanced as well as simple advice. The more the better for this to become a real repository. You may also repeat or link advice given elsewere on LessWrong.

Follow-Up to: A Guide to Rational Investing Financial Planning Sequence (defunct) The Rational Investor

What are your recommendations and ideas about financial effectiveness?

I seed this with a few posts about this found on LessWrong in the comments. What other posts and links about financial effectiveness do you know of?

Rules:

Each comment should name a single recommendation.
You should give the effectiveness in percent per period or absolute if possible.
Advice should be backed by evidence as usual.

General Advice (from Guide to Rational Investing):

Capital markets have created enormous amounts of wealth for the world and reward disciplined, long-term investors for their contribution to the productive capacity of the economy. Most individuals would do well to invest most of their wealth in the capital market assets, particularly equities. Most investors, however, consistently make poor investment decisions as a result of a poor theoretical understanding of financial markets as well as cognitive and emotional biases, leading to inferior investment returns and inefficient allocation of capital. Using an empirically rigorous approach, a rational investor may reasonably expect to exploit inefficiencies in the market and earn excess returns in so doing.

This is not investment advice and should not be relied on as such.

You need to consider tax when you make investment. If you do not, you are likely to invest badly. (Note: this discussion uses UK tax rates and concepts. The tax system may well be different in your jurisdiction, but the same general principles will likely apply.)

For example, suppose I invest £100,000 in the stock market for 10 years. Let's say that nominal returns are 7% (5% capital, 2% dividends, which I reinvest), and inflation is 2%. Therefore naively, I might expect to end up with £197,000 after 10 years, i.e. £161,000 in 2014 money. That's a 5% real return per year, which looks like a good investment.

But now let's say I have to pay SDRT at 0.5% on share purchases, and 38% on dividend income. Then, when you sell the shares you have to pay 28% in Capital Gains Tax (with an £11k exemption). So now you only end up with £131,000, i.e. £107,000 in 2014 money. That's a 0.7% real return per year, which looks like a terrible investment.

If I had invested in a more tax-efficient way (e.g. through an ISA, and with a fund reinvesting the dividends for me so they never become income) then I would have been able to get the full 5% real return. But I can only put £15,000 per year into an ISA, so this isn't a panacea.

Note that the difference between the 5% real return and the 0.7% real return is an order of magnitude. If I had invested in something with just half the real return of the stock market, but done so in a tax-advantaged way, it would be a better investment than investing in the stock market in a naïve way. In particular, there is no Capital Gains Tax on your primary residence in the UK.

Executive summary:

Investment returns are highly sensitive to tax rates.
Tax rates are often levied on the nominal, rather than the inflation-adjusted, gains, which makes them particularly damaging for long-term investments.
There may be legal ways to reduce or eliminate tax due on your investment.
The way that tax is levied on your investment can be far more important to your realised return than the underlying investment itself.

And so, on a meta-level:

Because taxation often matters more than the underlying investment, tax rates are a huge distortion of the market environment, favouring certain kinds of investments (housing) over others (providing capital for businesses).

I get a very different result when I run these numbers. I'm not from the UK so I may be interpreting the tax rules incorrectly, but here's the logic chain I used to model it (year one, so that it can be duplicated and logic verified);

If I invest 100,000 and pay the .5% stamp, I actually invest 99502.49
Dividends for the year would be 1990.05, of which I lose 746.27 to tax, leaving 1243.78 for reinvestment
Expected capital gains would be 4975.12 (99502.49 * 0.05)
Reinvesting the dividends of 1243.78 loses 0.5%, leaving 1237.56
Expected value at end of yea

... (read more)