Recently in the Investing for Growth (IFG) folder, a discussion took place about the merits and consequences of active portfolio management versus passive buy-and-hold strategies. And one of the questions raised concerned accounting for taxes in a model like IFG or Beating the Dow, where the model numbers accumulate without regard to tax consequences.

It's impossible, of course, to account accurately for taxes in any general model because of the variety of personal circumstances each of us faces, but the implication made during that discussion was that a buy-and-hold forever strategy will outperform an investment approach which trades more actively. And that *is* one aspect we can examine, at least on the surface.

One buy-and-hold strategy mentioned is the use of index funds. The returns for index funds mirror the market average of roughly 10%-11% over time and generate little in terms of taxable capital gains, provided one simply holds. But let's assume one is able to find an even better buy-and-hold investment, one generating a 15% average, year after year. (I don't know what this investment is, but let's assume one finds it.) And let's go even further and assume that the investment generates *no* taxes whatsoever. An initial investment of $50,000 held for 20 years at an annual return of 15% would become a portfolio worth $818,327.

Now, let's compare that to a similar $50,000 investment in an Investing for Growth portfolio. IFG has averaged 29% annually since 1980 (including the cost of commissions), so we'll use that as our return figure. But let's assume a complete turnover of the portfolio every year and the highest tax bracket for capital gains---28%. (Yes, short-term gains can be taxed at even higher rates, but since I'm going overboard in favor of the buy-and-hold approach, maybe you'll give me a point here.) So, each year the IFG portfolio returns 29%, then pays out 28% of the gains in taxes. At the end of the same 20-year test period, the IFG portfolio would be worth $2.2 million! ($2,218,498 to be precise for all you spreadsheet wizards checking my math.) That's 2.7 times as much as the buy-and-hold portfolio which we exempted from taxes.

The point is simply that more active accounts, even after the burden of taxes, don't necessarily lose out to the buy-and-hold-forever approach. As an investor looking for the best option for your investments, you must account for things like commissions and taxes, of course. But you must also look at the opportunity costs associated with whatever strategy you choose. If you prefer buy-and-hold, yes, you'll pay the government less in taxes perhaps, but what additional returns will you miss out on in the process?

Transmitted: 95-09-29