The Daily Dow
Thursday, October 23, 1997
by Robert Sheard
LEXINGTON, KY. (Oct. 23, 1997) -- Like the stock market itself, questions concerning stock market strategies often go in cycles. Recently, whether it's because we're heading toward the end of the year and investors are anxious to calculate their tax liabilities, or because of no reason in particular, I've been asked frequently what the affect of capital gains taxes are on the Foolish Four. "Doesn't the fact that you pay taxes every year (or 18 months) on the turnover ruin the approach?"
So today I'll share the response I typically give.
It's always an 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 like everyone in the industry, we have decided to figure all of our models without taxes, knowing full well that taxes are an issue, just not one easily generalized about.
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 at least a year but less than 18 months) 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 22.91% average returns since 1971 would still be 16.50%.
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 -- 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 $1,155,280. Now he sells them and has to pay the taxes (at 20%) for the whole series of gains (over $210,000 in one check to Uncle Sam). His total after 20 years by deferring taxes? $884,224.
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 $1.06 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% annual return. So in reality, the gap between the Dow Approach, which anyone can do (takes no clairvoyance) and the buy-and-hold approach (who has a 20-year crystal ball?) is much greater even than this example.
So, yes, taxes are a consideration, but they don't threaten the long-term effectiveness of the approach in the least. Fool on!
(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. ________________________________
Stock Change Last -------------------- T - 7/16 49.06 GM -1 5/16 70.25 CHV -2 15/16 83.50 MMM -1 1/16 99.56
Day Month Year
Day Month Year
FOOL-4 -1.62% 6.69% 23.93%
DJIA -2.33% -1.23% 21.70%
S&P 500 -1.84% 0.36% 28.34%
NASDAQ -2.15% -0.86% 29.45%
Rec'd # Security In At Now Change
1/2/97 153 Chevron 65.00 83.50 28.46%
1/2/97 179 Gen. Motor 55.75 70.25 26.01%
1/2/97 120 3M 83.00 99.56 19.95%
1/2/97 479 AT&T 41.75 49.06 17.51%
Rec'd # Security In At Value Change
1/2/97 479 AT&T 19998.25 23500.94 $3502.69
1/2/97 153 Chevron 9945.00 12775.50 $2830.50
1/2/97 179 Gen. Motor 9979.25 12574.75 $2595.50
1/2/97 120 3M 9960.00 11947.50 $1987.50
CASH $1167.51
TOTAL $61966.20