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The Daily Dow LEXINGTON, Kentucky (December 10) -- As the year starts winding down we get more and more readers wondering what the affects of taxes are on the beloved Dow Approach. "Doesn't paying the gains tax each year ruin the returns? Shouldn't you factor that into your models?"
It's always an touchy issue when you look at capital gains taxes, but since every investor faces a slightly different tax situation (based on personal income, state of residence, etc.) it's impossible to build taxes into a generic model return and have it be meaningful to very many people, so we have decided to figure all of our models without taxes, knowing full well that taxes are an issue, just not one easily generalized.
That said, however, it does help to look at worst-case scenarios. For example, the maximum federal capital gains tax rate for long-term holdings (held a year and a day or longer) is 28%. If the Dow Approach were to turn over completely each year (again, a worst-case scenario) and one paid the full 28% on all the gains each year, the after-tax return on the nearly 23% average returns since 1971 would still be about 16.5%.
Compare that to any buy-and-hold-forever scenario. With an index fund, you're not going to make more than 13%-15% on a pre-tax basis. With a group of well-chosen stocks, holding them through inevitable ups and downs, you're not likely to do much better than 15%-17% (again, on a pre-tax basis).
Keep in mind that buying-and-holding doesn't reduce the tax rate; it simply defers the tax bite until much later. That gives you an advantage in terms of extra compounding until the taxes are due, but that advantage comes at a bigger price, inevitably lower returns by not rotating out of stocks when they're over-valued.
So, let's compare the two approaches over 20 years. Investor Fred Rotation uses the Dow approach, starts with $50,000 and pays the 28% taxes each year. Investor Jim Everhold also begins with $50,000, buys ten terrific stocks and socks them away for the 20 years.
Jim Everhold picked a great basket of stocks; lucky Jim! They averaged 17% a year, turning his $50,000 into roughly $1.16 million. After 20 years he sells them and has to pay the taxes for the whole gain (over $309,000 in one check to Uncle Sam). His total after 20 years by deferring taxes? $845,802.
Fred Rotation pays the taxes each year and uses the simple Dow approach. After his 20 years, he's sitting on a nest-egg of roughly $1.07 million.
Now keep in mind, Jim Everhold represents the cream of the buy-and-hold crop. Very few investors can pick a group of stocks, hold them for two decades, and make a 17% return. So in reality, the gap between the Dow Approach, which anyone can do (takes no clairvoyance) and the buy-and-hold approach (who's got a 20-year crystal ball?) is much greater even than this example.
So, yes, taxes are a consideration, but they don't threaten the effectiveness of the approach in the least. Fool on! Today's Dow Numbers Stock Change Bid ------------------- DD - 5/8 95.13 CHV - 3/4 63.63 MMM +1 84.38 EK +1 81.25 IMN + 7/8 33.00
Day Month Year History
FOOL-4 -0.10% 2.26% 29.37% 29.37%
DJIA +0.14% 7.36% 26.50% 26.50%
S&P 500 -0.30% 5.99% 21.37% 21.37%
NASDAQ -0.28% 7.45% 24.75% 24.75%
Rec'd # Security In At Now Change
1/2/96 142 DuPont 69.88 95.13 36.14%
1/2/96 149 3M 63.76 84.38 32.33%
7/16/96 14 Imation 26.16 33.00 26.16%
1/2/96 380 Chevron 52.38 63.63 21.48%
1/2/96 148 E. Kodak 67.00 81.25 21.27%
Rec'd # Security In At Value Change
1/2/96 380 Chevron 19902.50 24177.50 $4275.00
1/2/96 142 DuPont 9922.25 13507.75 $3585.50
1/2/96 149 3M 9500.09 12571.88 $3071.79
1/2/96 148 E. Kodak 9916.00 12025.00 $2109.00
7/16/96 14 Imation 366.21 462.00 $95.79
CASH $1942.85
TOTAL $64686.98
Transmitted: 12/10/96
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