<FOOLISH WORKSHOP>

Annual Trading
vs.
Buy and Hold

by Jim Stevens ([email protected])

Burlington, VT (December 10, 1998) -- A discussion that pops up from time to time in the Workshop is the effect of annual taxes on our favorite Workshop models and whether it wouldn't be better to just buy and hold shares of a market index fund than to trade a portfolio of stocks every year. Today I'll look at how taxes change performance over the long run. Right now, the long-term capital gains tax limit is 20%. Let's figure the portfolio turns over every stock each year. This won't be the case in real life -- some stocks stay in a portfolio more than one year -- but I'll give the advantage to the buy-and-hold camp for the sake of this comparison.

Many of the workshop models boast historical returns above 25%. Some of us like to deduct a little "breathing room" from these lofty bull market backtests when evaluating whether they would be better then a straight Standard & Poor's 500 Index fund investment. To be on the low side, and more equivalent to some of the high yield models like the Dow Dividend or BSP strategies, I'll base the comparison on a hypothetical model returning 20%. Take off the 20% that you get skinned by the taxman each year, and your after-tax return is a hypothetical 16%.

The S&P 500 Index has a long-term annual growth rate (past twenty years) of under 15%, so we'll round it up to 15%. That's before accounting for taxes, which, while not due annually, must eventually be paid.

After 25 years of 15% a year tax-free compounding, a $20,000 portfolio in the S&P 500 Index fund or as a Standard & Poor's Depositary Receipts <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %> position would be worth $658,380. Now pay the taxes. Assuming you're still in the 28% tax bracket or higher, you'll owe taxes at 20% on the gains you've deferred for 25 years if you want to actually spend the money. The total after taxes is $526,703.

The same $20,000 in our hypothetical annually traded port, biting the tax bullet every year, would be worth $817,484 after 25 years. OK, you may have paid more taxes and maybe funded an extra White House intern along the way, but the important thing is you would have bested a buy-and-hold S&P 500 port nicely. You would have accomplished this by beating its pre-tax performance by a 5% return margin. Looking at some of the historical returns for the screens, this has been quite possible in the past.

If they apply in your area, you will also need to take state or municipal income taxes into consideration. That may put a further burden on the ability of the annually updated portfolios to still outperform the buy-and-hold portfolio after taxes. The important point, however, is that saving the annual taxes isn't as huge an advantage as it may first appear.

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