The Rules, Part 3: Minimize Friction

You can start early. You can stay patient. You can let compounding run. And still — silently, invisibly — fees and taxes can eat a quarter of your wealth before you ever notice.

In Part 2, I showed you what compounding does when you leave it alone.

I also made a passing comment — that a 1% fee drag is not just 1% of your returns. It is 1% off your compounding base every single year for decades. The cost is multiplicative. It compounds against you.

Part 3 is about that. About all the ways money leaks out of a portfolio without anyone announcing it. Fees. Taxes. The cost of being too active with your own money.

These are not dramatic losses. That is exactly what makes them dangerous. No single year feels painful. No single transaction feels like it matters. But over thirty or forty years, the accumulation of small frictions can cost you a third of your final wealth or more.

I want you to see the numbers. Then you will feel them.

What Friction Actually Means

When investors talk about friction, they mean any force that slows money down on its way to compounding.

The three main sources are:

Expense ratios — the annual fee a fund charges you to manage your money
Taxes — the cut the government takes when you realize a gain
Trading costs — the price you pay, in several ways, for moving in and out of positions

Each of these, alone, looks manageable. Together, over decades, they can quietly consume an enormous share of what you built.

Expense Ratios: The Fee That Never Stops

When you invest in a mutual fund or an ETF — a fund is a pooled investment vehicle where your money is combined with thousands of other investors to buy a basket of stocks — the company managing that fund charges you an annual fee called an expense ratio.

The expense ratio is expressed as a percentage of your total balance in the fund. It is deducted automatically, behind the scenes, before you ever see your return. You do not write a check. It simply reduces what would otherwise have been your gain.

Here is what that looks like in practice.

Assume you invest $10,000. The market returns 8% per year. You hold for 30 years.

Fund Type         Expense Ratio   Net Return   Value After 30 Years
--------------    -------------   ----------   --------------------
Actively managed   1.00%           7.00%            $76,100
Index fund         0.05%           7.95%            $99,100

An actively managed fund is one where professional portfolio managers decide what stocks to buy and sell, trying to beat the market. They charge for that service — typically 0.50% to 1.50% per year.

An index fund is different. It does not try to beat the market. It simply buys all the stocks in a major index — like the S&P 500, which tracks the 500 largest publicly traded companies in the United States — and holds them. Because no one is making active decisions, the costs are minimal. Major index funds today charge as little as 0.03% per year.

The difference in the table above is $23,000. On the same $10,000 starting investment. Earning the same underlying market return. Over the same 30 years.

That $23,000 gap is not a reward for better research or smarter decisions. It is simply the compounded cost of a fee difference that averaged less than one percentage point per year.

Here is the harder truth: the actively managed fund did not just cost you more in fees. It also had to overcome that 1% headwind every single year just to keep pace with the index fund. If it did not beat the market by more than 1% annually — consistently, for 30 years — you were worse off for paying it.

The evidence on this is not ambiguous. Over long periods, the majority of actively managed funds underperform their benchmark index after fees. Not all. Not always. But most, over time.

Trading Costs: What You Pay to Move

Transaction costs — what you pay to buy and sell investments — have fallen dramatically over the past decade. Most major brokers now offer commission-free trading on stocks and ETFs. That is a genuine improvement.

But trading is not free.

Bid-ask spreads still exist on every trade. The bid is the highest price a buyer is willing to pay for a stock. The ask is the lowest price a seller will accept. The gap between them — the spread — is a real cost. On highly traded stocks, this spread may be a penny or two. On thinly traded stocks or smaller ETFs, it can be much wider. Every time you buy, you pay the ask. Every time you sell, you receive the bid. The spread disappears in between.

The larger, quieter cost of active trading is behavioral. Every time you sell a position and buy another, you are making two bets that both have to be right — as I described in Part 1. The more often you trade, the more often you have to be right. And the more often you have to be right, the more opportunities you create to be wrong.

Frequent trading is not a strategy. It is friction wearing a strategy’s clothes.

Tax Drag: The Largest Hidden Cost

This is the one that surprises people the most.

When you sell a stock or fund at a gain, the IRS considers that a capital gain — the profit you made from the sale. Capital gains are taxable.

How much you pay depends on how long you held the investment:

Short-term capital gains: for investments held one year or less, gains are taxed as ordinary income — the same rate as your paycheck. Depending on your tax bracket, that could be 22%, 24%, 32%, or higher.
Long-term capital gains: for investments held longer than one year, gains are taxed at a lower rate — typically 0%, 15%, or 20%, depending on your income.

This is one reason why buy-and-hold is not just a discipline but a tax strategy. An investor who holds for years defers that tax event indefinitely. The unrealized gain keeps compounding in full. The government has not taken its cut yet, so the full balance stays in the market earning returns.

The moment you sell, you realize the gain, owe the tax, and reduce the capital that compounds going forward. As I showed you in Part 1, this difference is not small. A 20-year compounding difference between an investor who pays tax annually and one who defers it can exceed 35% of the final balance.

Tax-Advantaged Accounts: The Most Powerful Tool You Have

The good news is that the tax code gives ordinary investors a specific tool to shelter their compounding from annual taxation. It is called a tax-advantaged account, and most people who work have access to at least one.

401(k): A retirement account sponsored by your employer. You contribute money from your paycheck before taxes are taken out — meaning you get a deduction today. The money grows without being taxed each year. You pay taxes when you withdraw in retirement, ideally at a lower rate than your working years.

Roth IRA: An individual retirement account you open yourself. You contribute money you have already paid taxes on — no deduction today. But the money grows tax-free. When you withdraw it in retirement, you owe nothing. No capital gains. No income tax. Nothing.

Both accounts are designed to remove the annual tax drag from compounding. Inside a Roth IRA, every gain, every dividend, every dollar of compounding is permanently sheltered from taxation. That is a substantial structural advantage.

If you have a Roth IRA option available to you and you are not using it, you are leaving one of the most valuable financial instruments in the U.S. tax code sitting on the table.

Tax-Loss Harvesting: A Brief Note

In a taxable account — one outside of a 401(k) or IRA — there is a specific technique worth knowing: tax-loss harvesting.

It works like this. If one of your holdings has fallen in value, you can sell it at a loss. That loss can be used to offset gains elsewhere in your portfolio, reducing your total tax bill for the year. You can then immediately reinvest the proceeds in a similar (but not identical) investment to maintain your market exposure.

This is not a strategy for beginners to implement on their own without research. But it is a legitimate tool for reducing friction in taxable accounts, and financial advisors and robo-advisors often use it automatically.

The point is not to manufacture losses for their own sake. The point is that the tax code allows you to use realized losses to reduce the drag of realized gains — and in a taxable account, that is worth understanding.

A Note to Luca and Lili

Fees and taxes do not feel like losses. That is the trap.

A 1% expense ratio feels like nothing. A capital gains tax on a stock you sold feels like a small inconvenience, worth it because you moved on to something better. A few trades here and there feel like staying engaged, staying sharp.

What they feel like and what they cost are two very different things.

The numbers in this post are not hypothetical. The $23,000 gap between an actively managed fund and an index fund over 30 years will happen to a real investor who makes that choice and does not look closely at the fee line. The difference between paying capital gains taxes annually versus deferring them for twenty years is a third of a portfolio balance for some investors — real money that went to the government instead of compounding for them.

None of this is complicated to fix. Use index funds. Use tax-advantaged accounts. Trade as infrequently as possible. These are not advanced strategies. They are basic ones. They work because they keep friction low, and low friction means compounding gets to run.

Start now. Keep costs down. Let time do the rest.

The One-Sentence Summary

Fees and taxes do not feel painful in any given year, but they compound against you just as surely as returns compound for you — and minimizing both is one of the most reliable ways to keep more of what the market gives you.

Next: Part 4 — The Case for Index Funds. We have established buy-and-hold, compounding, and the cost of friction. In Part 4, we put it together: why a low-cost, diversified index fund is the single best starting point for most investors — and what the evidence actually shows about trying to beat it.

— Jim