<THE FOOLISH FOUR>
by Robert Sheard
LEXINGTON, KY. (July 13, 1998) -- Frequently I'm asked if an investor wouldn't be better off deferring taxes by investing in a Standard & Poor's 500 Index fund and holding for the very long term rather than paying capital gains taxes every year using the Foolish Four model. Now that Congress has passed a bill to lower taxes on one-year holdings (assuming President Clinton signs it), this is a good time to revisit that question and recalculate the comparison.
For the past 20 years, the S&P 500 Index has returned an annualized gain of 16.65% (source, Ibbotson Associates). Let's assume for a minute that an investor holding the S&P 500 Index in a mutual fund isn't paying any management fees and isn't taxed on capital gains distributions or dividends until the end of another 20 years. (This isn't really the case, but it makes for a simple comparison stacked in the index's favor.)
A $10,000 investment, then, would grow to $217,618 after 20 years at this pace. But remember, all the taxes have been deferred. There's still a tax liability on that growth of $207,618. Let's use the proposed 20% tax rate. That would mean a tax bill of $41,524, leaving a grand total after 20 years of $176,094.
Over the past 20 years, by comparison, the Foolish Four has returned a compounded rate of 21.22% a year (pre-tax). If we assume complete turnover in the portfolio every year (which also stacks the scenario against the Foolish Four unfairly, as the actual turnover is generally about 50%), and the proposed 20% capital gains tax rate, the after-tax return for the Foolish Four is 16.98%.
Of course in real life, dividends are taxed as ordinary income, so in both portfolios, part of the taxes would be at a rate different from the 20% example I'm using here (higher or lower, depending on one's tax bracket).
If we invested that same $10,000 and received an after-tax gain of 16.98%, the total after 20 years would be $230,267. Even paying taxes each year, the Foolish Four portfolio in this scenario finished the 20-year period with nearly 31% more money after taxes than the index fund did.
Keep in mind also that this 20-year historical return does not extend back to the horrid bear market of the early 1970s. Including that awful market, the Foolish Four shone even brighter, recording a gain for the two-year period while the S&P 500 lost some 40% of its value.
All told, then, taxes do not derail the success of this strategy and even deferring the taxes through buying and holding an index fund does not provide a better after-tax return over the long run. With the new 20% tax rate in effect, ironically, even retirement plans allowing pre-tax money look a little less useful because the whole account is taxed at one's ordinary income tax rate upon pulling the money out of the account. While it's true that contributions are pre-tax money and save on one's income tax burden up front, it's very possible that the growth on those accounts will be taxed at a higher rate than the capital gains taxes you'd pay if you invested the money in a taxable account.
If you retire in the 28% ordinary bracket, for example, instead of the 15% bracket (which is possible depending on the size of one's portfolio withdrawals each year), you're actually going to pay those extra eight percentage points on your asset growth you wouldn't have had to pay under the capital gains tax rates in a taxable account. Food for thought when you're deciding where to invest that next savings deposit.
Current Dow Order | 1998 Dow Returns
[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]
07/13/98 Close
Stock Change Last -------------------- UK - 1/4 53.38 IP - 7/16 42.88 MO - 5/16 39.75 EK - 7/16 73.13 |
Day Month Year
FOOL-4 -0.68% 0.77% 9.42%
DJIA -0.11% 1.61% 15.02%
S&P 500 +0.08% 2.77% 20.07%
NASDAQ +1.16% 3.74% 25.16%
Rec'd # Security In At Now Change
12/31/97 291 Union Carb 42.94 53.38 24.31%
12/31/97 206 Eastman Ko 60.56 73.13 20.74%
12/31/97 289 Int'l Pape 43.13 42.88 -0.58%
12/31/97 276 Philip Mor 45.25 39.75 -12.15%
Rec'd # Security In At Value Change
12/31/97 291 Union Carb 12494.81 15532.13 $3037.31
12/31/97 206 Eastman Ko 12475.88 15063.75 $2587.88
12/31/97 289 Int'l Pape 12463.13 12390.88 -$72.25
12/31/97 276 Philip Mor 12489.00 10971.00 -$1518.00
CASH $754.73
TOTAL $54712.48
|