Taxes, Compounding, and the Bigger Picture

Charlie Munger once made a very simple observation that many investors overlook. He explained that if an investor owns a business that compounds at 15% per year for 30 years and pays a single lump sum 35% tax only at the end, the investor still earns roughly 13.3% annually after taxes. He also warned that trying too hard to reduce taxes often becomes “one of the great standard causes of really dumb mistakes.”

Although these words were spoken many years ago, they remain highly relevant today. Many investors spend enormous amounts of time worrying about taxes while paying far less attention to the quality of the businesses they own. Ironically, business quality, long-term earnings growth, and disciplined investing usually have a much larger impact on wealth than most tax planning decisions.

This is especially true for investors whose intended holding period stretches over ten years or even several decades.

The Incredible Power of Compounding

Albert Einstein is often popularly credited with calling compound interest the eighth wonder of the world, although historians cannot confirm that he actually said it. Regardless of the quotation’s origin, the mathematical principle is undeniable.

Compounding means that returns generate additional returns. Instead of earning returns only on your original investment, you also earn returns on previous gains.

For example, suppose an investor starts with $100,000. If the investment compounds at 15% annually:

The remarkable aspect is that most of the wealth is created during the later years rather than the earlier years.

This is why time is one of the most valuable assets an investor can possess. Every additional year allows compounding to work on a much larger capital base.

Why Delaying Taxes Can Be Extremely Valuable

Now consider Charlie Munger’s example. Instead of paying taxes every single year, imagine paying one tax bill only after the investment has compounded for thirty years. The government effectively allows your unrealised gains to continue compounding during the entire holding period.

This creates what investors often describe as an “interest-free loan” from the tax authorities. Although the tax eventually has to be paid, the money that would otherwise have been paid earlier remains invested and continues generating additional returns for many years.

This explains why Munger calculated that a 15% annual return becomes roughly a 13.3% annual return after paying a single 35% tax at the end. While 13.3% may appear only slightly lower than 15%, over several decades, it still represents extraordinary wealth creation.

The lesson is simple. Deferring taxes allows more capital to remain invested for longer periods.

Frequent Trading Creates Hidden Costs

Many investors enjoy buying and selling stocks frequently. Some believe they can constantly improve their portfolios by reacting to market news, analyst reports, or daily price movements. However, every sale can potentially create several costs:

Each individual cost may appear small. Together, however, they continuously reduce the amount of money available for future compounding. Even professional fund managers often underestimate how damaging unnecessary turnover can become over long periods.

A portfolio that compounds quietly for decades frequently outperforms one that is constantly adjusted, even if every individual trade initially appears reasonable.

The Cost of Chasing Small Tax Savings

Charlie Munger warned that excessive efforts to minimise taxes often lead investors to poor decisions. This happens surprisingly often.

For example, an investor may refuse to sell a poor-quality company simply because selling would trigger capital gains tax. The company continues deteriorating while management destroys shareholder value. Eventually, the investment falls substantially, and the investor loses far more than the tax they originally hoped to avoid.

The opposite mistake also occurs. An investor may sell an exceptional company solely because they have found a tax-efficient alternative. Years later, the original company may have multiplied several times in value while the replacement performs poorly. The investor saved some tax but sacrificed a much larger amount of future wealth.

Good investment decisions should primarily be driven by business fundamentals rather than tax considerations. Taxes matter. Business quality matters even more.

Exceptional Businesses Usually Dominate Tax Considerations

History shows that many of the world’s greatest companies have compounded shareholder wealth for decades. Businesses possessing durable competitive advantages, excellent management teams, high returns on invested capital, recurring cash flows, and disciplined capital allocation often continue growing for many years.

If such businesses are purchased at reasonable prices and held patiently, the gains from long-term compounding frequently outweigh concerns about short-term taxes.

This principle explains why many legendary investors maintain concentrated portfolios with relatively low turnover. They spend far more time identifying exceptional businesses than searching for tax loopholes. Finding a business capable of compounding at high rates for twenty or thirty years is exceptionally difficult. Once such a business is found, unnecessary selling often interrupts the very process that creates extraordinary wealth.

My Perspective on U.S. Estate Taxes for International Investors

My own view is that many international investors spend too much time worrying about U.S. estate taxes on U.S.-listed stocks. The issue certainly deserves understanding. However, I do not believe it should become the primary factor determining whether someone invests in exceptional American businesses.

The United States remains home to many of the world’s strongest companies across technology, healthcare, consumer goods, industrials, financial services, software, and many other sectors. Avoiding these businesses solely because of estate tax concerns may result in giving up decades of potential compounding. For many investors, that opportunity cost could become far larger than the estate tax risk itself.

At the same time, every investor’s circumstances differ. Family structure, country of residence, citizenship, tax treaties, asset size, and estate planning arrangements all influence the actual level of risk. Therefore, estate taxes should be evaluated as part of an overall financial plan rather than viewed in isolation.

Opportunity Cost Is Often the Bigger Risk

Investors naturally focus on visible costs such as taxes. Less attention is paid to invisible costs. One of the highest invisible costs is opportunity cost.

Opportunity cost measures what an investor gives up by choosing one course of action over another. Suppose an investor avoids owning a collection of exceptional companies because of tax concerns. Instead, the investor purchases businesses with weaker economics simply because they appear more tax-efficient.

Over twenty or thirty years, the difference in business performance may exceed many millions of dollars for a sufficiently large portfolio. The tax savings become insignificant compared with the lost compounding.

This is why opportunity cost deserves equal, if not greater, attention.

Focus on What You Can Control

Successful investing rarely depends upon predicting interest rates, elections, or short-term market movements. Instead, investors should focus on factors within their control.

Each of these decisions compounds over time. Small improvements made consistently for decades often produce remarkable outcomes.

Simplicity Usually Wins

One of Charlie Munger’s greatest strengths was reducing complicated ideas into simple principles. His message about taxes is remarkably straightforward.

Taxes matter. But they should not dominate investment decisions. Long-term ownership of exceptional businesses allows compounding to perform its magic. Frequent trading, excessive tax avoidance strategies, and constant portfolio adjustments often interrupt that process.

For international investors, U.S. estate taxes deserve proper understanding and prudent planning. Nevertheless, they should generally be viewed as one component of a broader investment framework rather than the defining factor in portfolio construction. Investors who reject outstanding businesses solely because of estate tax concerns may unknowingly incur a much higher cost through forgone compounding over several decades.