Taxes, inflation and the stock market

According to Bob, the world's worst market timer, becoming rich is easy. Have a savings plan and invest the money in the stock market only when indices are skyrocketing. Ignoring any coming downturns and repeating this scheme you will make you a millionaire.

Millionaire by the numbers but still a wealthy man

This sounds too good to be true, doesn't it? Indeed, from what I read, Ben Carlson, who came up with Bob's story only considers the nominal values. So what happens if we take taxes and inflation into account?

Long story short: Taxes and inflation will eat up about 50% of the nominal performance. Anyhow, after 40 years gritting his teeth, Bob is a wealthy man, despite his badly timed investments into a total return ETF on the Dow Jones.

The following table lists Bob's investments over time. The first column shows the investment year, the second one the invested amount in $. Column three and four show the performance of the ETF. Column three shows the performance when all dividends are reinvested.  Thus $ 1 invested in 1972 will return $ 58.38 in 2013. Column four takes into account that Bob needs to pays 33% taxes on his dividends. Last but not least, column five shows the inflation from the time of investing till the year 2013. Thus a $ 1 earned in 1972 is worth only 1/5.55 in 2013.

Bob's investments
Year Investment in $ Total return (2013) Total return minus taxes (2013) Inflation till 2013
1972 6,000 5838 % 3835 % 555 %
1987 46,000 1499 % 1245 % 204 %
1999 68,000 191 % 174 % 139 %
2007 64,000 141 % 136 % 112 %

Ignoring taxes and inflation, Bob invests $ 184,000 over 40 years and receives $ 1.250 Mio (deviation from Ben's stated 1.1 Mio as I only have year end data available). Giving a return of 684%.

Taking taxes and inflation into account Bob's real return suffers from following effects.

  1. Taxes reduce the nominal performance by 20% to $ 1.008 Mio.
  2. Due to inflation, $ 6,000 form 1972 are worth $ 33,000 in 2013. Thus, in terms of 2013 value, he really invested $ 293,040.

Therefore, Bob's real return is 344% ( $ 293.040 / $ 1.008 Mio), roughly half of the nominal 684%.

Data sources

Dow Jones price index: Wikipedia
Dow Jones dividends: Stock Market Analysis Model from http://observationsandnotes.blogspot.com/
US-Dollar inflation: Bureau of Labor Statistics (PDF)