<THE FOOLISH FOUR>

Foolish Four Report
by Robert Sheard

LEXINGTON, KY. (Jan. 9, 1998) -- A lot of readers are initially skeptical about the Foolish Four approach because of taxes. Doesn't selling stocks every year give up too much in taxes to make this approach worthwhile, except in an IRA?

While there's no doubt that taxes hurt the long-term returns, if you're investing in a taxable account, you're going to face that burden eventually with any equity strategy you adopt, so let's do some comparisons using historical returns as hypothetical examples.

If you're investing in the Foolish Four approach and updating your portfolio once a year, the maximum federal capital gains tax rate you face is 28%. (If you're in the 15% tax bracket, you would only pay that amount in taxes.) Dividends, of course, are taxed as ordinary income and could be taxed as high as 39.6% at the federal level. But let's make the comparison a little easier and assume a flat 28% tax rate on all proceeds for the Foolish Four investor.

Let's also raise the bar higher than necessary and assume that the Foolish Four portfolio turns over entirely each year. In reality, the average turnover is closer to 50%, but we'll calculate the returns as if you replaced all four stocks every year.

Since 1961, the Foolish Four has returned an annualized gain of 18.1%. After paying 28% to Uncle Sam, that leaves roughly a 13% after-tax gain each year. If you were to invest $25,000 and achieved 13% a year (after taxes) for the next 35 years, you would have a portfolio worth a grand total of $1,801,713.

Now let's compare that to an alternative you might be considering. If you were to invest that same $25,000 in an S&P 500 Index fund and left it alone, you wouldn't have to pay capital gains taxes until the end of the 35 years. (In reality, you'd still have to pay some taxes as you go because of dividends and capital gains distributions from the mutual fund, but for simplicity's sake, let's defer all the taxes to the end in this example.)

Since 1961, the S&P 500 Index has returned an annualized 11.9% (with dividends reinvested). If that rate were to repeat itself for the next 35 years (the same assumption I used to calculate a projection for the Foolish Four example), your index fund value would increase to $1,128,653. But you're still sitting on a pretty hefty tax burden.

Too many investors believe that when they buy and hold forever, they avoid taxes. That's not true unless you give away the assets to a charity or pass them on to heirs at your death. If you want to have access to the money in your lifetime, eventually you must sell and pay the taxes or set up some pretty nifty estate-planning vehicles. (And when you figure them out, pass along the knowledge to me. I dream about being rich someday, too.)

Now let's reduce your index fund value by a tax rate of 18%. That's the capital gains rate that will become available in a few years for holdings of five years or more. While we're stacking the deck against the Foolish Four, let's go all the way. It can handle it. Get out your checkbook; that's $198,658 to the government, please! Your index fund's final value is really only $929,995.

Of course taxes hurt, but don't be swayed by the belief that paying them every year is a bad idea in favor of paying them when you retire. It's not always best to push them off. In this hypothetical example, which may or may not reflect tax reality in 35 years, the pay-as-you-go method with the Foolish Four generated an extra $871,718 over the buy-and-hold-forever approach with an index fund, even though the Foolish Four method's tax rate was ten percentage points higher and was pulled out of the portfolio every year.

Compare after-tax returns rather than raw tax rates to see which approach is best for you. You might just discover that paying as you go is better in the long run. Fool on!

TODAY'S NUMBERS
Stock  Change   Last 
 -------------------- 
 UK   -1  7/16  41.50 
 IP   -2  1/8   42.63 
 MO   -1  1/8   45.44 
 EK   -1  3/16  62.44 
 
            
                    Day   Month    Year 
         FOOL-4   -3.08%  -0.25%  -0.25% 
         DJIA     -2.85%  -4.15%  -4.15% 
         S&P 500  -2.97%  -4.40%  -4.40% 
         NASDAQ   -3.36%  -4.28%  -4.28% 
  
     Rec'd   #  Security     In At       Now    Change 
  
  12/31/97  206 Eastman Ko    60.56     62.44     3.10% 
  12/31/97  276 Philip Mor    45.25     45.44     0.41% 
  12/31/97  289 Int'l Pape    43.13     42.63    -1.16% 
  12/31/97  291 Union Carb    42.94     41.50    -3.35% 
  
  
     Rec'd   #  Security     In At     Value    Change 
  
  12/31/97  206 Eastman Ko 12475.88  12862.13   $386.25 
  12/31/97  276 Philip Mor 12489.00  12540.75    $51.75 
  12/31/97  289 Int'l Pape 12463.13  12318.63  -$144.50 
  12/31/97  291 Union Carb 12494.81  12076.50  -$418.31 
  
  
                              CASH     $77.19 
                             TOTAL  $49875.19