Because dividend and realized capital gains distributions are subject to state, local and federal taxation, after-tax returns (for taxable accounts) are the only returns that matter. However, most individual investors focus on pre-tax returns. Focusing on pretax returns can lead to costly decisions.

One explanation for this behavior is that investors are unaware of just how devastating an impact taxes can have on returns. Another might be that they’re subject to “mental accounting” — returns earned go into one pocket, but the tax bill is paid from another pocket, and the two are never tied together.

The greater turnover of actively managed funds makes them tax inefficient relative to passively managed funds. And the academic literature provides us with a large body of evidence demonstrating that taxes are the biggest expense most investors face — greater than management fees or commissions. In other words, the quest for pretax alpha can generate negative after-tax alpha.

For example, the 1993 study “Is Your Alpha Big Enough to Cover Its Taxes?” found that only 7 percent of funds studied over a 10-year period beat a passive alternative on an after-tax basis, compared to 21 percent winning on a pretax basis. They concluded: “The preponderance of evidence is so convincing we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.” Let’s look at the findings of another major study on the subject.

The study “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” investigated:

The pretax and after-tax efficiency of actively managed funds
The likelihood of pretax and after-tax outperformance
The relative size of outperformance versus the relative size of underperformance
Here’s a summary of its findings:

The average fund underperformed its benchmark by 1.75 percent per year before taxes and by 2.58 percent on an after-tax basis.
Just 22 percent of the funds beat their benchmark on a pretax basis. The average outperformance was 1.4 percent, with the average underperformance being 2.6 percent. However, on an after-tax basis, just 14 percent of the funds outperformed. The average after-tax outperformance was 1.3 percent, while the average after-tax underperformance was 3.2 percent. The risk-adjusted odds against outperformance are about 17:1.
The story is actually worse than it appears, because the data above contains survivorship bias – 33 funds disappeared during the time frame covered by the study. Also, the study only covered funds with more than $100 million in assets, so it’s likely the survivorship bias is understated. Funds that have successful track records tend to attract assets. Funds with poor records tend to lose assets or are “put to death,” never reaching the $100 million threshold of the study.

This study was updated in 2011 and concluded that the typical approach for managing taxable portfolios – acting as if taxes cannot be reduced or deferred — remains the industry standard. Yet, the authors estimated that the typical active fund needs to generate a pretax alpha of more than 2 percent per year to offset the tax drag resulting from their active strategies — and most can’t accomplish that feat. The finding of a tax drag in excess of 2 percent is consistent with the findings from other studies.

It’s important to consider that because of the two bear markets we experienced in the first decade of this century, the impact of taxes on returns has been less than what many investors have experienced long term. That’s why it’s important to look at data from prior periods.

The evidence is so overwhelming that Ted Aronson, an institutional fund manager with about $20 billion of assets under management, offered this advice: “Once you introduce taxes active management probably has an insurmountable hurdle.”

Given the evidence, it’s not surprising that most fund managers focus on pretax returns. However, ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes you can make. You can avoid this mistake if you keep the following points in mind:

Because of the important impact on returns, passively managed tax-managed funds should be the investment vehicles of choice for taxable accounts.
Exchange-traded funds are also appropriate vehicles, as their structure generally enables them to be highly tax efficient.
If you do use actively managed funds, they’re best held in tax-deferred accounts, where their tax inefficiency won’t impact after-tax returns.

Read more: http://moneywatch.bnet.com/investing/blog/wise-investing/why-taxes-may-be-the-most-important-issue-you-address-in-your-portfolio/2680/#ixzz1TzdkYH5o

While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to find better advice on living longer than do not smoke, drink alcohol in moderation, eat a hearty breakfast and a balanced diet, get at least a half hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life.

I have spent over 35 years managing financial risks for two leading financial institutions as well as advising individuals and multinational corporations on the management of finan­cial risks. Based on those experiences, I have compiled a list of rules that will give you the greatest chance of achieving your financial goals.

Do not take more risk than you have the ability, willingness, or need to take. Plans fail because investors take excessive risks. The risks unexpectedly show up, and investors with 30 ­year horizons can turn into investors with 30-day horizons. That leads to the abandonment of plans. When developing your plan, consider your horizon, stability of income, abil­ity to tolerate losses, and the required rate of return.

Never invest in any security unless you fully understand the nature of all of the risks. If you cannot explain the risks to your friends, you should not invest. Fortunes have been lost because people did not understand the nature of the risks they were taking.

The more complex the investment, the faster you should run away. Complex products are designed to be sold, not bought. You can be sure the complexity is designed in favor of the issuer, not the investor. Investment bankers don’t play Santa Claus providing you with higher returns because they like you.

Risk and return are not necessarily related; risk and expected return are related. If there were no risk, there would not be higher expected returns.

If the security has a high yield, you can be sure the risks are high, even if you cannot see them. The high yield is like the shiny apple with which the evil queen entices Snow White. Investors should never confuse yield with expected return. Snow White could not see the poison inside the apple. Similarly, investment risks may be hidden, but you can be sure they are there.

A well-thought-out plan is the necessary condition for success­ful investing; the sufficient condition is having the discipline to stay the course, rebalance, and tax-loss harvest as needed. Unfortunately, most investors have no written plan. And emotions such as greed and envy in bull markets and fear and panic in bear markets, can cause even well-thought ­out plans to be trashed.

Having a well-thought-out investment plan is the necessary condi­tion for achieving your financial goals. Integrating the investment plan into a well-thought-out estate, tax and risk management (insurance of all kinds) plan is the sufficient condition. The best investment plans can fail due to events unrelated to finan­cial markets. For example, the breadwinner dies without sufficient life insurance, there is an accident and there is insufficient liability coverage, or disability or long-term ­care insurance is needed but is not in place.

Do not treat the highly improbable as impossible, nor the highly likely as certain. Investors assume that if their horizon is long enough, there is little to no risk. The result is that they take too much risk. Taking too much risk causes inves­tors with long horizons to become short-term investors. Stocks are risky no matter the horizon. And remember, just because something has not happened doesn’t mean it cannot or will not.

The consequences of decisions should dominate the probability of outcomes. We buy insurance against low-probability events (such as death) when the consequences of not having the insurance can be too great to accept. Similarly, investors should insure their portfolios (by having an appropriate amount of high-quality fixed income investments) against low-probability events when the consequences of not doing so can be too great to contemplate.

The strategy to get rich is entirely different than the strategy to stay rich. One gets rich by taking risks (or inheriting it). One stays rich by minimizing risks, diversifying, and not spending too much.

Value stocks are the stocks of companies that have:

Low price-to-earnings ratios
Low price-to-book ratios
Low price-to-dividend ratios
Low price-to-sales-and-cash-flow ratios

In other words, their prices are depressed. The logical reason for the low prices is that value stocks are the stocks of riskier companies. To entice you to take incremental risks, their prices have to be depressed enough so you’re compensated with sufficiently high expected returns. And value investors have been rewarded with a large risk premium. From 1927-2010, the value premium was 4.8 percent.

Academics have long debated the source of the value premium. Some believe it results from economic risks, while others believe it’s more of a behavioral story — investors persistently underestimate the power of the reversion to the mean of abnormal earnings growth. My own view is that while most of the premium is a result of economic risks, there’s probably some truth to the behavioral story.

Research papers supporting the risk story have found that there are some simple and compelling reasons for the value premium. For example, value stocks are typically characterized by greater leverage and higher volatility of both earnings and dividends — a risky combination.

Studies have also found that the returns of value stocks are more procyclical than the returns of growth stocks — they’re more risky than growth stocks in bad times (and less risky in good times, though to a lesser extent). Because investors are risk averse, they require a large premium to accept that risk.

Value companies also tend to be distressed, with high leverage and high uncertainty of cash flow. Therefore, shocks to the default spread (the spread between highly rated bonds and lower-rated credits) explain the cross-section of returns and is consistent with value being a measure of distress risk.

And finally, studies have found turnover is negatively correlated with returns — low-turnover, less-liquid stocks have higher returns. This is consistent with a risk story. Investors demand higher returns as compensation for the incremental trading risks associated with low turnover stocks. And low turnover stocks display many characteristics commonly associated with value stocks.

“Yeah,” I tell them. “Ignore hot stock tips.”

From what I can tell, most lay people operate under a huge misconception about the stock market. They believe that the surest way to make money is to buy a stock just before it is about to take off, then cash in when the price has doubled or tripled. They aren’t the least bit interested in incremental gains or holding for the long term. Instead, they lust after the adrenalin rush that comes with making a fast buck.

In their quest for an immediate payoff, they focus on risky stocks with a great “story” – a mining exploration company that’s supposedly about to hit the motherlode, or a technology company whose latest invention promises to revolutionize (insert industry name here). It doesn’t matter if the company has no earnings now; the important thing is that the cash will soon begin pouring in like Niagara Falls.

These short-term “investors” – a more accurate term is gamblers – gravitate to initial public offerings, hot sectors (think Internet shares in the late nineties or Chinese stocks a couple of year ago), takeover scenarios and anything else that promises a big payday for very little of the investor’s time or effort.

Are some investors successful at this game? Sure. They’re usually the ones who are privy to insider knowledge, have access to sophisticated high-frequency trading algorithms or are just plain lucky. But the vast majority of ordinary people who treat the stock market like a giant casino will get casino-like returns. Reinforced by an occasional win at the slots, they’ll keep going back for more, frittering away their cash in a futile attempt to make their capital grow.

The casino mentality prevails with “anti-gamblers” as well. For every punter who sees the market as a place where quick fortunes are made, someone else sees it as a place where fortunes are lost. “Invest in stocks? You gotta be crazy!” is the familiar refrain. These two groups could not be more different in their behaviour, yet both view the stock market as largely a gambling parlour.

And they’re both wrong.

Investors who “get” the stock market aren’t seduced by the allure of quick profits. Nor are they scared away by risk, which they accept in measured doses because they know that without risk, there is little reward. They focus, not on short-term winnings, but on the growth of their investment over years or decades. They accept that the stock market is manic depressive in the short run, but that the key to building wealth is to buy and hold high-quality companies whose sales, earnings and dividends grow over the long term. If they can buy them at an attractive price, all the better.

Warren Buffett’s words of wisdom

The stock market is merely a tool for acquiring these companies. As Warren Buffett once said: “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

One reason I am a big fan of dividend growth investing is that it is the antithesis of the casino approach. To prosper from companies whose dividends increase regularly, an investor has no choice but to buy and hold. It is a get-rich-slow strategy that rewards patience and commitment.

Knowing (or at least strongly suspecting) that a company will be increasing its dividend regularly is a powerful incentive to stay invested (assuming, of course, that the company’s fundamentals haven’t changed in some dramatic way), regardless of the market’s inevitable ups and downs.

Investors who trade frequently, on the other hand, usually pay the price in lower returns. That’s partly because taxes and commissions eat into their capital, but also because individuals often make decisions based on emotion.

In a 2000 paper titled “Trading is Hazardous to Your Wealth,” Brad Barber and Terrance Odean of the University of California studied the trading activity of 66,465 households at a large discount broker between 1991 and 1996. The U.S. market returned an average of 17.9 per cent annually during this period, but households whose trading frequency was in the top 20 per cent made 11.4 per cent. In a separate paper, the authors found that 80 per cent of day traders in Taiwan lost money over a typical six-month period.

As the late value investor Benjamin Graham once said: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

Now that’s a stock tip worth remembering.

Stats to ponder:

1 per cent: Proportion of day traders in a Taiwanese study who were “predictably profitable,” according to University of California finance professor Brad Barber, quoted in The New York Times.

8.2 per cent: Annualized total return of the S&P 500 for the 20 years ended Dec. 31, 2009.

3.2 per cent: Annualized return of the average mutual fund investor over the same period, according to Dalbar Inc., reflecting fees and the tendency of investors to buy and sell at the wrong times.

John Heinzl

Unfortunately, personal finance has not yet become a required subject in high school or college, so you might be fairly clueless about how to manage your money when you’re out in the real world for the first time. If you think that understanding personal finance is way above your head, though, you’re wrong. All it takes to get started on the right path is the willingness to do a little reading – you don’t even need to be particularly good at math.

To help you get started, we’ll take a look at eight of the most important things to understand about money if you want to live a comfortable and prosperous life.

1. Learn Self Control
   If you’re lucky, your parents taught you this skill when you were a kid. If not, keep in mind that the sooner you learn the fine art of delaying gratification, the sooner you’ll find it easy to keep your finances in order. Although you can effortlessly purchase an item on credit the minute you want it, it’s better to wait until you’ve actually saved up the money. Do you really want to pay interest on a pair of jeans or a box of cereal? (To learn more about credit, check out Understanding Credit Card Interest and our Debt Management feature.)

   If you make a habit of putting all your purchases on credit cards, regardless of whether you can pay your bill in full at the end of the month, you might still be paying for those items in 10 years. If you want to keep your credit cards for the convenience factor or the rewards they offer, make sure to always pay your balance in full when the bill arrives, and don’t carry more cards than you can keep track of.

2. Take Control of Your Own Financial Future
   If you don’t learn to manage your own money, other people will find ways to (mis)manage it for you. Some of these people may be ill-intentioned, like unscrupulous commission-based financial planners. Others may be well-meaning, but may not know what they’re doing, like Grandma Betty who really wants you to buy a house even though you can only afford a treacherous adjustable-rate mortgage.

   Instead of relying on others for advice, take charge and read a few basic books on personal finance. Once you’re armed with personal finance knowledge, don’t let anyone catch you off guard – whether it’s a significant other that slowly siphons your bank account or friends who want you to go out and blow tons of money with them every weekend. Understanding how money works is the first step toward making your money work for you. (To find out how to have fun and still save money, see Budget Without Blowing Off Your Friends.)

3. Know Where Your Money Goes
   Once you’ve gone through a few personal finance books, you’ll realize how important it is to make sure your expenses aren’t exceeding your income. The best way to do this is by budgeting. Once you see how your morning java adds up over the course of a month, you’ll realize that making small, manageable changes in your everyday expenses can have just as big of an impact on your financial situation as getting a raise. In addition, keeping your recurring monthly expenses as low as possible will also save you big bucks over time. If you don’t waste your money on a posh apartment now, you might be able to afford a nice condo or a house before you know it. (Read more on budgeting in our Budgeting 101 special feature.)
4. Start an Emergency Fund
   One of personal finance’s oft-repeated mantras is “pay yourself first“. No matter how much you owe in student loans or credit card debt and no matter how low your salary may seem, it’s wise to find some amount – any amount - of money in your budget to save in an emergency fund every month.

   Having money in savings to use for emergencies can really keep you out of trouble financially and help you sleep better at night. Also, if you get into the habit of saving money and treating it as a non-negotiable monthly “expense”, pretty soon you’ll have more than just emergency money saved up: you’ll have retirement money, vacation money and even money for a home down payment.

   Don’t just sock away this money under your mattress; put it in a high-interest online savings account, a certificate of deposit or a money market account. Otherwise, inflation will erode the value of your savings.

5. Start Saving for Retirement Now
   Just as you headed off to kindergarten with your parents’ hope to prepare you for success in a world that seemed eons away, you need to prepare for your retirement well in advance. Because of the way compound interest works, the sooner you start saving, the less principal you’ll have to invest to end up with the amount you need to retire, and the sooner you’ll be able to call working an “option” rather than a “necessity”.

   Company-sponsored retirement plans are a particularly great choice because you get to put in pretax dollars and the contribution limits tend to be high (much more than you can contribute to an individual retirement plan). Also, companies will often match part of your contribution, which is like getting free money. (To learn more, see Understanding The Time Value Of Money and Retirement Savings Tips For 18- To 24-Year-Olds.)

6. Get a Grip on Taxes
   It’s important to understand how income taxes work even before you get your first paycheck. When a company offers you a starting salary, you need to know how to calculate whether that salary will give you enough money after taxes to meet your financial goals and obligations. Fortunately, there are plenty of online calculators that have taken the dirty work out of determining your own payroll taxes, such as Paycheck City. These calculators will show you your gross pay, how much goes to taxes and how much you’ll be left with, which is also known as net, or take-home pay.

   For example, $35,000 a year in California will leave you with about $27,600 after taxes in 2008, or about $2,300 a month. By the same token, if you’re considering leaving one job for another in search of a salary increase, you’ll need to understand how your marginal tax rate will affect your raise and that a salary increase from $35,000 a year to $41,000 a year won’t give you an extra $6,000, or $500 per month – it will only give you an extra $4,200, or $350 per month (again, the amount will vary depending on your state of residence). Also, you’ll be better off in the long run if you learn to prepare your annual tax return yourself, as there is plenty of bad tax advice and misinformation floating around out there. (To learn all about your taxes, visit our Income Tax Guide.)

7. Guard Your Health
   If meeting monthly health insurance premiums seems impossible, what will you do if you have to go to the emergency room, where a single visit for a minor injury like a broken bone can cost thousands of dollars? If you’re uninsured, don’t wait another day to apply for health insurance; it’s easier than you think to wind up in a car accident or trip down the stairs. You can save money by getting quotes from different insurance providers to find the lowest rates. Also, by taking daily steps now to keep yourself healthy, like eating fruits and vegetables, maintaining a healthy weight, exercising, not smoking, not consuming alcohol in excess, and even driving defensively, you’ll thank yourself down the road when you aren’t paying exorbitant medical bills.
8. Guard Your Wealth
   If you want to make sure that all of your hard-earned money doesn’t vanish, you’ll need to take steps to protect it. If you rent, get renter’s insurance to protect the contents of your place from events like burglary or fire. Disability insurance protects your greatest asset - the ability to earn an income - by providing you with a steady income if you ever become unable to work for an extended period of time due to illness or injury.

   If you want help managing your money, find a fee-only financial planner to provide unbiased advice that’s in your best interest, rather than a commission-based financial advisor, who earns money when you sign up with the investments his or her company backs. You’ll also want to protect your money from taxes, which is easy to do with a retirement account, and inflation, which you can do by making sure that all of your money is earning interest through vehicles like high-interest savings accounts, money market funds, CDs, stocks, bonds and mutual funds. (Find out all you need to know about insurance in Understand Your Insurance Contract, Five Insurance Policies Everyone Should Have and Insurance 101 For Renters.)

A Financial Basis for Life
Remember, you don’t need any fancy degrees or special background to become an expert at managing your finances. If you use these eight financial rules for your life, you can be as personally prosperous as the guy with the hard-won MBA.