The Daily Dow
Tuesday, November 04, 1997
by Robert Sheard

LEXINGTON, KY. (Nov. 4, 1997) -- Since Congress enacted legislation changing the capital gains tax rate and holding-period requirements, there's been quite a bit of interest in whether this should prompt Foolish Four investors (and Dow Dividend Approach investors in general) to extend their holding periods from twelve to eighteen months.

As you may know, we have our own Foolish researcher locked away in a damp and dingy cell, slaving away at testing the historical returns one would have achieved in recent decades using an eighteen-month holding period rather than the traditional twelve-month cycle. We hope to have some results to examine in a few weeks. If you haven't been following this story in recent months, I summarized the results of one research study, performed in 1995 on a twenty-year database, which suggested that the optimal holding period for the Dow high-yield stocks is eighteen or nineteen months. If our own research confirms this finding, it's a great boon to Dow investors because it would allow us to extend our holding periods, which reduces trading costs, qualifies us for a lower tax rate, and may produce even better raw returns. But the jury is still out until we can either confirm or reject those findings.

Today, however, let's look at three other aspects of this issue.

First, if your account is an IRA, the issue isn't as much of a concern. For tax purposes, holding periods are irrelevant in IRAs because everything is taxed at ordinary tax rates when you withdraw the money at retirement (in a regular IRA), or completely tax free (in the new Roth IRAs, which become available in 1998). So the question for IRA holders is what period is the optimal holding period for pure returns. Even if the eighteen-month cycle proves slightly better, however, you may still wish to continue using a twelve-month cycle in an IRA so that your update coincides with your annual savings deposit into the IRA. If you're using an eighteen-month cycle, you'll either have to do something else with your annual deposit every other year while you're between portfolio adjustments, or you'll need to split your portfolio into three parts and stagger each third by six months in separate Dow groups. A little more complicated, but manageable for larger amounts. Using a twelve-month cycle, though, makes it simple. Stick your new $2,000 in, update the holdings as needed, and forget it for another year.

Second, in taxable accounts, even the twelve-month cycle isn't always going to cost you the higher 28% tax rate levied on one-year holdings. On average, about half of a Dow portfolio will turn over in any given year. So the half you retain for a second twelve months would then qualify as a longer-term holding and be taxed when you ultimately sell at the lower 20% rate. In other words, sticking to the old plan will still provide us a lower tax rate for about half of our holdings -- not a bad deal, even if the eighteen-month holding cycle doesn't prove to hold a great advantage for overall returns.

Third, the difference between the twelve- and eighteen-month holding periods required to generate the same after-tax return probably isn't as large as you might suspect. Working with the historical return for the Foolish Four since 1971 (22.91%), let's assume the worst and calculate the taxes on the entire gain, as if the whole portfolio turned over every year. A tax of 28% lowers the pre-tax return of 22.91% to an after-tax gain of 16.50%. (28% of 22.91 is 6.41. Subtract that from 22.91 to get 16.50.)

To achieve the same rate of return after taxes at the lower tax rate of 20% requires a pre-tax return of just 20.625%. (X - 0.20X = 16.50. X equals 20.625.) At this level, then, we're only faced with a pre-tax difference in the returns of 2.29 percentage points. That's not a huge difference, as you can see.

Now if the eighteen-month cycle can generate returns of at least 20.625% before taxes, it makes good sense to switch to it in taxable accounts. Your trading costs would be lower because you're only adjusting the portfolio once every year-and-a-half, and your after-tax returns would be higher. But as I said, we're not through testing that history yet, and the jury must remain out until we have firm numbers to compare. In the meantime, no one is worse off by staying the course with the traditional twelve-month holding cycle, and, in fact, some of the gains will be taxed at the new lower rate anyway because they're held for more than one cycle.

These are the issues involved in making the decision to use an eighteen-month holding period or the traditional one-year cycle. For the most part, I don't believe it's a monumental issue either way. The approach was terrific before the tax reform and the worst-case scenario today is that it got slightly better for the stocks we hold in successive cycles. The best potential case would be, of course, gravy: lower trading costs, better returns, and lower taxes.

Stay tuned. I'll announce any details from our research as soon as they cross my cyber-desk.

(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. ________________________________

TODAY'S NUMBERS

Stock Change Last -------------------- T - 3/8 49.38 GM - 5/8 66.63 CHV - 1/2 86.19 MMM + 11/16 92.88

Day Month Year FOOL-4 -0.47% 2.19% 22.15% DJIA +0.19% 3.32% 19.24% S&P 500 +0.19% 2.86% 27.00% NASDAQ +0.06% 2.36% 26.34% Rec'd # Security In At Now Change 1/2/97 153 Chevron 65.00 86.19 32.60% 1/2/97 179 Gen. Motor 55.75 66.63 19.51% 1/2/97 479 AT&T 41.75 49.38 18.26% 1/2/97 120 3M 83.00 92.88 11.90% Rec'd # Security In At Value Change 1/2/97 479 AT&T 19998.25 23650.63 $3652.38 1/2/97 153 Chevron 9945.00 13186.69 $3241.69 1/2/97 179 Gen. Motor 9979.25 11925.88 $1946.63 1/2/97 120 3M 9960.00 11145.00 $1185.00 CASH $1167.51 TOTAL $61075.70