The Dow Approach
The Dow Approach
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FOOL GLOBAL WIRE LEXINGTON, Kentucky (January 23) -- A reader asked me to comment on today's Andrew Tobias column (available at www.ceres.com), which was itself a response to a question about the Motley Fool's beloved Foolish Four approach. And as I have no desire for this to be seen as the start of a flame war, let me point out that I agree with many things in his column. First, we all know that past performance is no guarantee of future performance, but since it's the only thing we can measure, it's what we talk about. That said, though, when you're talking about decades of performance, most investors feel a little bit of security that the approach is sound, as Tobias mentions. He also asserts a long-held Fool belief that most managed mutual funds just can't beat the index funds, so as a first step, if you have to be in funds, at least check out index funds. But his comparison between the Foolish Four approach and an index fund after taxes is where we part company. His claim is that if one rotates every year with the Foolish Four, and thus incurs capital gains taxes each year, then the buy-and-hold approach with an index fund, which defers taxes, is more attractive. Not so unless you cook the numbers as he has in his example. First of all, he reduces the Foolish Four return to 20% because he doesn't believe the rate it has posted since 1971 (23%) is sustainable. Fair enough. But then he declares a tax rate of 40%, including federal and state taxes and a mixture of long- and short-term capital gains. Un uh! This approach only generates long-term capital gains if you update a year and day after your last update. No short-term penalties here, which means the federal rate can't go higher than 28%. Then he declares a 15% annual return for the index funds. But that overstates the actual return of the Vanguard Index 500 fund since its inception in 1976 (14.2% according to the Vanguard representative I called). Now if you're going to declare that the Foolish Four can't possibly sustain its historical 25-year growth rate, isn't it a little bit unfair to overstate the actual historical growth rate you calculate for the index fund? But a more glaring disparity is that Tobias uses only a 35% combined federal and state tax rate for the index fund. That won't do either. Both approaches are taxed each year on dividends and both are taxed upon any sale at the long-term tax rate. So those rates have to be the same or the comparison is meaningless. Choose 35% or 40% or whatever rate applies to you, it doesn't matter, but the rate must be the same for both investment approaches. Let's compare apples to apples using actual historical return rates and the same tax rate (say a combined federal and state rate of 35%). After you take 35% out of the annual growth rate for the Foolish Four of 23%, you're left with an after-tax rate of 14.95%. And that assumes the entire portfolio turns over every year, which of course doesn't happen. Compound that for 25 years and a $10,000 portfolio grows to $325,630, after taxes. Put the same $10,000 into an index fund at Vanguard's long-term return of 14.2% and let it grow tax-deferred for the 25 years. That comes out to $276,473. Now take out the deferred taxes you owe on the gains from the original $10,000 at 35%, and the total value after taxes is only $183,207. That's only 56% of the value of the Foolish Four portfolio after 25 years. So while I agree with Tobias that taxes are important and that index funds beat out the vast majority of managed funds, I don't at all agree that taxes render the Dow approach a weaker alternative than buying-and-holding an index fund. The numbers, when you compare actual rates of return and equitable tax rates, simply don't support that conclusion. |
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