How the IRS Makes You a Better Investor

As I put the final touches on this year's tax return, I always pay extra attention to my Schedule D form. This is the form where investors list what they sold this year, along with the capital gains and losses earned. The form also requires you to separate your short-term gains and losses from your long-term ones.

Getting the short end of the stick
Out of curiosity, this year I decided I would go back a few years and examine my Schedule D for each year to see how the results stacked up over the years. What I found was both enlightening and frustrating.

Over the years, the substantial majority of my capital losses seemed to hang out in the short-term section of the form. Under IRS rules, short-term gains and losses are those which are held for less than one year. From what I could see, at least for myself, trying to "invest" in a business for less than a year rarely paid off.

Go long ... real long
Thankfully for me, most of my investments were classified as long-term. Here, the picture was much brighter. For my long-term holdings, I mostly had gains. Wonderful businesses like PetroChina (NYSE: PTR  ) , Eagle Bulk Shipping (Nasdaq: EGLE  ) , and Central European Distribution (Nasdaq: CEDC  ) were good to me for several years.

And even better, the IRS encouraged me to stick with them for the long haul. With lower tax rates for long-term gains, the IRS gets less of my profits when I hold my investments more than a year. So not only did I make more money by hanging out for the long term, but I also paid much less tax than if I had attempted to speculate and profit in the short term.

A valuable lesson
I'd bet that most investors -- if they looked back -- would notice similar results from their investments. Good businesses are not focused on the next quarter or two. They tend to provide strong performance over a period of years.

What really brought this lesson home for me was that most of my short-term mishaps actually became excellent long-term investments. For instance, I bought shares of Walter Industries (NYSE: WLT  ) because of its wonderful collection of businesses, including its 2006 spin-off of Mueller Water Products (NYSE: MWA  ) . But I sold them soon thereafter when the stock didn't perform as I'd thought it would. While Mueller has continued to run a bit dry, this business offers favorable prospects over the long haul. Moreover, the lag in Mueller has been readily compensated by Walter's stellar performance.

But when investors succumb to the short-term price swings, they shift their focus away from long-term business fundamentals to short-term stock volatility. As Ben Graham famously said, "In the short term the market is a voting machine, but in the long term it is a weighing machine." Thus, to focus on the short term would be akin to trying to catch a falling knife.

Prudent investors should only use short-term price volatility as a window of opportunity to buy good businesses at temporarily cheap prices. Then they should ignore the short-term noise and allow the business time to prosper. In time, the solid business fundamentals should overcome any short-term price slides.

It's not often that one finds something pleasant to say about the IRS, but they do pay you to wait by taxing your long-term profits at lower rates than short-term profits. And the truth is that the real money in stocks is made over multi-year periods.

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