Warren Buffett is famously known for buying and holding stocks for long periods of time, sometimes forever. In his 1988 Berkshire Hathaway annual letter to shareholders, he even stated, “Our favorite holding period is forever.” When Buffett finds a gem of a company with great leadership, and the ability to consistently deliver value to shareholders – he’s willing to ride it … as long as that lasts.
There is good reason to stick with companies for long periods of time; one of them, being taxes. As soon as you sell your shares in a company, there will be taxes owed.
So, the longer you can hold on, the greater the return on your money.
Let’s look at how taxes can impact your long-term holdings.
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Long-Term 30 Year Investment Scenario
It’s Christmas Day – imagine that you’ve just became a proud new parent! The first thing you do is try to get some sleep. But the second thing is that you want to give your child a solid head start, by providing a long-term investment account.
Given your child was born on Christmas Day, you feel lucky, inspired, and blessed – so you decide to deposit $122,520.22 (The numbers in 12/25/2022) as your child’s investment. Your plan is to manage this account for 30 years, and then on the 30th year, you will sell everything and surprise your child with a wonderful surprise.
You’ve been reading and inspired by your favorite investor, Warren Buffett, and you’ve located a wonderful company, with a management team you can trust, a track record of growth, and a long runway for the future. You put the entire $122,520.22 into this one company and hold on.
After 30 years, just as you had planned, you sell all the shares and are left with $3.67M! To your surprise the management team delivered a solid 12% annual return, including dividends. But your child won’t be receiving that full amount. Why? Taxes.
After liquidating the stock, you have to pay long-term capital gains. For simplicity, let’s use a 20% tax rate. So how much will your child really get? About $2.96M.
Even though your return was 12% each year, the real annualized return was 11.2% after taxes. Taxes are typically the largest expense when it comes to investing, operating a business, and even in your personal life. In this case of the $3.67M the amount of taxes is ~$710K – quite a large chunk of money.
Two – 15 Year Investments (30 Years Total)
Let’s look at an alternative way of investing this money.
You will invest the same sum of money – $122,520.22. This time, instead of investing it in one company for 30 years – you will invest in 1 company for 15 years, cash out; and then invest in another company for 15 years.
What method will provide your child with more money?
- Year 1-15 at 12% annually = ~$671K subtracting $110K in taxes – totaling $561K
- Year 16-30 at 12% annually = ~$3.07M subtracting $502K in taxes – totaling $2.57M
- OR ~$392K less than buying and holding one company for 30 years.
Key Lesson – Hold for Higher Returns and Deferring Taxes
Holding your stocks for longer periods of time reduces the overall taxes that you pay. Each time you sell, you must also consider the tax implications and be sure that the new investment will outperform both the previous company and the taxes associated with the selling.
This image shows you the more you sell your investments, the more taxes you pay, resulting in a lower return. Assuming that your expected return (12% in our case) is the same for both. This points to the reason why Buffett likes to buy and hold forever. The longer you can hold, the better your returns will be due to compounding.
Buffet invests in companies that he believes are the best, and he will not sell until he finds another company that will outperform his investment, and the given tax consequences.
The Concept Behind Holding
The idea behind holding for long periods of time has to do with deferring taxes – or pushing back the date in which taxes are due.
Each time you sell and have to pay taxes, that tax money can no longer compound.
In the first year of our $122,520.22 investment, we earned $14,702. Technically we owe 20% in taxes on that money, or $2,940. But we don’t have to pay that tax until we sell our shares. These are the rules that our government have defined for us. So, that $2,940 is ‘deferred taxes,’ and we are allowed to keep the deferred tax ‘working for us.’
Taxes are inevitable, but the longer you can postpone the payment of taxes, the better off you’ll be – especially if that money owed is ‘working for you.’ A portion of that growth will go to you, and the rest will be paid to the government. This idea of deferral is one of Buffett’s favorite metrics in business – he calls this ‘float.’
Buffett’s idea of ‘float,’ is using money that is essentially free, because it is owed to someone else. In business, this could be money owed to vendors, taxes owed, payroll owed, pre-paid income, among other things. If you’re more interested in ‘float,’ check out this article: Learn Why Warren Buffett Loves Float
In 1988, Buffett also purchased a massive amount of Coca-Cola stock. In the same paragraph in which he quoted, “Our favorite holding period is forever,” he mentioned that he had purchased Coca-Cola shares, and as amazing as it might sound, this is the stock in which he has held the longest – 34 years now! Over that time, he has made billions of dollars on that single investment and has yet to sell even a single share.
Another reason to hold onto your investments for long periods of time is good investment ideas are really hard to find. If you hold a stock for a period of time, you need to have a plan on where to allocate that money.
If you bought some shares in a company and decided to sell them after 1 year (the minimum for long-term capital gains rates), you will pay 20% tax on your gains. You now have to generate a 18.75% return in order to get 15% (after tax) on your next 1-year investment.
Therefore, the idea of buying and holding for long periods of time is the most ideal. There aren’t very many good ideas that come along, and you should be choosing quality over quantity when it comes to investing in individual stocks. You will improve your chances of success by doing the necessary research and identifying the wonderful companies and only investing in those.
What Kind of Companies are the Best Investments?
To make long-term investments, you must be sure that the company will also stay in business and thrive during this period. Companies that fall into this category have plenty of reinvestment opportunities to continue that growth. Another important factor that Buffett likes to take note of is, what kind of “moat” does the company have? This is the idea that the company possesses a sustainable competitive advantage over other companies. This protects the long-term growth and profits of a company, making them safer investments.
It’s important to understand that holding for as long as possible doesn’t mean never sell. Buffett does sell shares of companies from time to time as well. Companies make many changes over the years and must also be aligned with your investment criteria.
Here is a list of Buffett’s longest held companies and how many years he’s held them.
Conclusion
When you find a wonderful company to buy at a fair price, you want to hold onto that company as long as you can. One reason, is that it is very hard to find wonderful companies worth investing in. The second reason is that when you sell shares you must now pay the taxes on all your profits. This reduces your portfolio size and the amount that you can invest into the next company. So, when you are making the decision to sell shares, you should be sure that your new investment prospect can outperform the old one, including the amount of taxes that you will now have to pay. The idea here is to defer taxes as long as possible when you are invested in great companies. In the meantime, you are earning money on the deferred tax portion of your investment, and this is one of the real edges in investing – especially when you are holding forever.
