The Daily Dow
Friday, July 18, 1997
by Robert Sheard

LEXINGTON, KY. (July 18, 1997) -- A frequently asked question about the Dow Dividend Approaches concerns the impact of taxes and trading costs on the returns we list in our Dow Statistics Center. Let's tackle trading costs first.

With the variety of deep-discount brokers available today, trading costs for this type of approach have never been more affordable. Commissions can be as low as $10 a trade, regardless of the number of shares one buys or the price per share. There's no longer a penalty for the investor with a modest portfolio who's forced to buy in odd lots. To a large extent, the deep-discounters have leveled the playing field for us.

If a Dow Approach portfolio typically sees a 50% turnover each year, the total number of trades per year for a Foolish Four portfolio would be four to six, depending on whether one rebalances all of the positions when updating the holdings. That represents a total commission cost for the year of $40-$60, which is reasonable for even the smallest portfolios. In fact, let's just assume you add extra cash each year in an amount equal to your commissions and simply remove them from the equation. They're practically a non-factor if you choose the right broker.

That leaves taxes. The real comparison is whether the after-tax returns for an approach like the Foolish Four holds up to a buy-and-hold strategy with an Index fund. Let's begin with the index fund. Since 1971, a composite basket of all 30 Dow stocks (including dividends) has averaged 13.3% a year. Assuming the DJIA and the S&P 500 move almost in lock-step over time, I'll use that return for our imaginary index fund.

If one invests $20,000 today in our mythical index fund and defers taxes for the next 25 years, at a rate of 13.3%, the portfolio would be worth $453,709. This assumes that no taxable distributions are made through the years, which isn't the case, but for simplicity's sake, we'll run with it. At the end of the 25 years, then, there's a tax due on the entire amount of gains. If we tax them at the new proposed long-term tax rate of 20%, this reduces the portfolio value by $86,742. The after-tax value for the index fund investment, then, is $366,967.

Now let's work with the same assumptions for a Foolish Four portfolio. Its historical return since 1971 (pre-tax) has been 22.9% a year. We'll use the same tax rate of 20%, but pay taxes on the entire gain each year. That actually overstates the taxes since the entire portfolio won't typically turn over, but again, for simplicity's sake and to be conservative, we'll pretend the portfolio has 100% turnover each year.

The annual after-tax return for the Foolish Four under this scenario would be 18.3%. Compound that growth over 25 years using the same original investment of $20,000 and the total portfolio value grows to $1,335,515.

The Foolish Four would return 264% more than the index fund under these conditions, even paying taxes on gains each year as one goes. The real comparison is the after-tax return, and the lure of deferred taxes is only a genuine benefit if it doesn't require one to give up superior returns. In fact, getting superior returns while paying the taxes each year not only benefits the investor, but also the government in the form of increased tax revenue. (Just what they need, huh? More money to waste on government bureaucracy.) When looking at your own tax situation, try to factor in as many relevant elements as possible and then see which of two alternatives looks the most attractive to you.

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________


1997 Foolish Four Model
Stock  Change   Last
--------------------
T    -   9/16  34.44
GM   -   3/8   55.00
CHV  -1  3/4   75.63
MMM  -1  1/2   98.31

          Day   Month    Year
        FOOL-4   -1.53%  -1.19%   0.95%
        DJIA     -1.62%   2.73%  22.37%
        S&P 500  -1.75%   3.41%  23.57%
        NASDAQ   -1.33%   7.34%  19.90%

    Rec'd   #  Security     In At       Now    Change
   1/2/97  120 3M            83.00     98.31    18.45%
   1/2/97  153 Chevron       65.00     75.63    16.35%
   1/2/97  179 Gen. Motor    55.75     55.00    -1.35%
   1/2/97  479 AT&T          41.75     34.44   -17.51%


    Rec'd   #  Security     In At     Value    Change
   1/2/97  120 3M          9960.00  11797.50  $1837.50
   1/2/97  153 Chevron     9945.00  11570.63  $1625.63
   1/2/97  179 Gen. Motor  9979.25   9845.00  -$134.25
   1/2/97  479 AT&T       19998.25  16495.56 -$3502.69


                             CASH    $767.60
                            TOTAL  $50476.29