<THE FOOLISH FOUR>
Foolish Four Report
by Robert Sheard
LEXINGTON, KY. (Feb. 23, 1998) -- With the new tax laws in effect for the 1997 returns we're all preparing now, there's naturally a lot of interest in the Dow Area about tax ramifications. So let me address two topics that appear often in our message folders.
First, the question about whether 12 or 18 months is the best holding period has yet to be determined definitively. A group of readers on the website message boards has done some terrific work on the matter, and as you undoubtedly know, Bob Price (TMF Sandy) is building a massive database, one product of which will also be a look at the holding-period debate.
The real problem in any such test, as I see it, is the fact that even on a 12-month holding period, many of the stocks in the Foolish Four will have been held for two years, meaning some gains would be taxed at 28% and others at 20%, clouding the research picture between a pure 12- and 18-month comparison. More on that issue when Sandy's test is complete.
But a more fundamental issue is whether the Dow Approaches really make sense when you can buy an S&P 500 Index fund or an S&P 500 Spyder and hold forever, deferring capital gains taxes and letting compounding have its full effect every year. Which approach is really better?
All we have to go by, of course, is the current tax situation and the historical growth rates for several approaches, so for this comparison to be meaningful we have to accept the limitations of such assumptions. The S&P 500 and Foolish Four may not perform in the future in the same way they have in the past, and tax laws can change at any time. (In fact, there's already a move afoot to scratch the 18-month holding period just added and revert to 12 months at the lower rate.)
But for now, we have the reality of four different holding periods and rates (one to take effect in a few years). If you hold a stock a year or less, you pay your ordinary tax rate. If you hold more than a year and no more than 18 months, you pay the lower of your ordinary rate or 28%. If you hold more than 18 months, you pay 10% if you're in the lowest tax bracket; otherwise you pay 20%. In the future, an 18% rate will be levied on holdings of at least five years.
So, let's look at a scenario using today's tax rates and pretend the last 37 years repeat themselves.
For the last 37 years, the S&P 500 Index has returned 11.9% a year (with dividends reinvested). Skip the fact for now that you'd have to pay annual taxes on the dividends. If you deposited $10,000 at this rate for the next 37 years, your total portfolio would be worth $640,786.
You would still owe a tax liability, however, on all but your original $10,000 investment. If we use the longest-term capital gains rate of 18%, that total value is reduced by $113,541, leaving a grand total value of $517,245.
Over the same 37 years, however, the Foolish Four has returned 18.2% a year -- 6.3 percentage points higher per year. If we assume the 12-month capital gains rate of 28% on the entire gain each year, which as we know, overstates the actual tax rate because there's not 100% turnover every year, that 18.2% pre-tax return is really 13.1% after taxes.
As 13.1% is higher than the pre-tax return for the buy-and-hold-forever S&P 500 option, it's obvious which approach will win out over the long run. At the end of the 37-year test, the Foolish Four after taxes would be worth $950,860.
So even though one pays a whole lot more in taxes by rotating holdings each year, such a plan achieves, in this example, a total worth 84% more than the deferred tax plan used in buying and holding the S&P 500 indefinitely.
Even if the S&P 500 Index had been in a completely tax-free program, the fully taxed Foolish Four approach generated a larger portfolio. So, yes, taxes will undoubtedly take a chunk out of the Foolish Four returns every year, but the real comparison is after-tax returns, and on that score, the taxable Foolish Four still out-paces even a tax-free Index Fund.
Make the total comparison, Fools, and then see which plan looks the best to you. Fool on!
[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]
TODAY'S
NUMBERS
Stock Change Last -------------------- UK - 9/16 46.38 IP - 5/8 47.50 MO - 1/2 41.31 EK - 9/16 65.38 |
Day Month Year
FOOL-4 -1.53% 2.65% 4.36%
S&P 500 +0.38% 5.90% 6.98%
NASDAQ +1.37% 8.18% 11.55%
Complete numbers will be available tomorrow again.
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