I mentioned in an earlier post that the tax consequences of trading in and out of mutual funds should be considered. I haven't seen analysis on this before, but I worked out some numbers. My assumptions are that you start out with $10,000 initial investment, and get 10% return per year, and remain fully invested for all cases:
1. If you do no trading, at the end of 20 years, your investment will grow to $67,275. After selling to get the cash out, you would end up with $58,683 assuming 15% federal taxes for long-term cap gains. Assuming 10% state income tax, you would end up with $52,956.
2. If you sold your mutual fund every two years, and immediately reinvested your proceeds into another fund, you would owe 15% long-term cap gains at the end of the 2nd, 4th, 6th, etc years. At the end of the 20 yrs, you would end up with $51,676, or $7,007 less than if you didn't do any trading. You paid federal taxes earlier, and so lost the opportunity to make gains off the amount that you paid to taxes. If you have 10% state income tax, you would end up with $43,172, which is now $9,784 less than if you didn't do any trading.
3. If you traded mutual funds every year, and didn't hold them long enough to qualify for long-term capital gains, you would end up with $29,177 for the 35% federal short-term gain/10% state income tax case.
In other words, the tax consequences eat deeply into your returns even if you immediately reinvest proceeds. And even long-term trading of mutual funds have significant tax consequences. Of course if you are doing tax-loss selling and offsetting your capital gains, that is a different story.
I ran some more numbers. In order to neutralize the lost opportunity on those early taxes you paid, you would have to earn 12% return every year for the federal tax long-term gain only case, and 14% return every year for the federal tax long-term gain + state tax case.
That translates to consistently outperforming that mutual fund you sold by 20-40% year in and year out for 20 years, sounds like a pretty difficult feat to me.