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Taxes and Investing -- Part 2

By Al Levit

GLENDALE, CA (April 6, 1999) -- Yesterday, we began our discussion of the ill effects of taxes on investing performance. We concluded that taxes take a nasty bite out of the gains on the sell of winning stock. But then again, holding a stock to avoid taxes is only delaying the inevitable. Heck, taxes have to be paid at some point. Now. Later. Does it really matter?

If I gave you a choice between an investment strategy that made 15% a year or one that made 20%, which would you pick? The answer seems so obvious that you might think this is a trick question. Given today's headline and yesterday's discussion, you'd be absolutely right, because in many cases you'd be better off choosing the 15% strategy. The reason behind this is taxes.

To illustrate let's examine two investors, Foolish Freddie and Trading Terry, and start them out with $10,000 each. We'll let them invest for 30 years under these ground rules:

1) Foolish Freddie will buy stock in one company at the very beginning, and leave his money there. It's a good Rule Maker, but not necessarily Microsoft or Pfizer, and so it "only" returns an average of 15% per year during the period.

2) Trading Terry is shrewder. She's got a real eye for when companies have hot and cold streaks, so she can move in and out of investments from time to time. Sometimes this costs her, but overall she wins more than she loses. As a result, she can outperform Foolish Freddie to the tune of 5% per year. Doing that year in and year out is really something. Therefore, her average return is 20% per annum.

3) In order for Terry to trade effectively, silly timing rules can't restrict her. As a result, she rarely, if ever, will hold a stock for a year and a day to get long-term capital gains treatment. As a result, she winds up paying tax on her gains at ordinary income rates, which we'll assume are about 35% between the federal and state combined.

Last but not least, we'll assume at the end of 30 years that both Freddie and Terry are well into retirement, and need to cash out of their stocks for some very good reason. Thus, they both take their gains on their investments and pay their tax.

Here's where things get interesting. Terry has been paying tax all along, so she has relatively little tax left to pay. Freddie, on the other hand, hasn't paid a dime of tax yet. All these years that Terry has been trading frenetically and paying annual taxes, Freddie has been holding his investment and letting it compound. Moreover, all of Freddie's tax will be paid at long-term rates (about 25% for federal and state combined). I've put together a spreadsheet that illustrates what happens to Terry and Freddie on a year-by-year basis available for your perusal. After 30 years, here's the bottom-line:
Before Tax Portfolio Value After Tax Portfolio Value
Trading Terry
(20% pre-tax return)
$415,390 $391,159
Foolish Freddie
(15% pre-tax return)
$662,118 $499,088

Of course, this is just one example. If Terry can't outperform Freddie by 5% year-in and year-out (which is a very ambitious goal), things will be a lot worse for her. Maybe Freddie can do better than 15% per year (maybe he will pick Microsoft or Pfizer). Or, maybe Terry can restrict herself to one trade a year. In that case, all she needs to do is outperform Freddie by about 3.5% a year. This is still no easy task.

Bottom-line, the Wise may advertise constantly about their quarterly returns, and the brokers may talk about the advantages of trading, but the government has stacked the deck in favor of the buy-and-hold strategy. The Feds have made sure that Trading Terry will have an uphill climb against Foolish Freddie.

Not only that, but at least Trading Terry is outperforming the market, and by a substantial margin at that. Think of all our not-so-Foolish friends that have their personal investments in underperforming mutual funds. Most of these funds are notoriously tax-inefficient, and they throw off taxable distributions each year while they earn less than the market averages. Even Trading Terry's after-tax returns would look great compared to the average mutual fund.

That's it for today. Tomorrow, I'll conclude this tax series with a look at how Fools should be measuring their own returns.

Finally, let me take a moment to point out my new message board handle, TMF Early. My old handle, CashKingAl, is just a memory now (please, no tears). The other Rule Maker managers also have TMF handles now. Phil Weiss is TMF Grape (formerly MrShihTzu), and Rob Landley is TMF Oak (formerly Oak).

Also, regarding yesterday's Question of the Week, there may have been some confusion as to how the topic of T. Rowe Price's (Nasdaq: TROW) options grant came up on the Companies board. It all began on the subject thread, A question for Phil Weiss, which started as a simple question for Phil's (TMF Grape) opinion on T. Rowe Price. The discussion took a turn, however, when Mycroft (692738) posted his dismay at the company's enormous option grant. The question of whether management is acting unethically is a serious one. Let's give it some careful thought and keep the discussion rolling. (Click on the Question of the Week link above to see the question and post replies.)

Fool on,

Al

04/06/99 Close
Stock  Change    Bid
AXP   -2 3/16  123.25
CHV   -1 1/16  89.56
CSCO  +  13/16 115.25
KO    -  11/16 59.81
GPS     ---    67.75
EK    -  13/16 62.94
XON   +  1/2   72.69
GM    +3 1/2   91.06
INTC  +2 15/16 130.44
MSFT  -  7/8   94.06
PFE   -2 3/16  140.19
SGP   +1       56.63
TROW  +  9/16  32.94
YHOO  -4 1/4   214.88

                   Day   Month    Year  History
        R-MAKER  -0.03%   4.72%  16.64%  47.59%
        S&P:     -0.24%   2.45%   7.53%  33.03%
        NASDAQ:  +0.12%   4.12%  16.90%  55.07%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     94.06   140.36%
   6/23/98   34 Cisco Syst    58.41    115.25    97.31%
    5/1/98   55 Gap Inc.      34.37     67.75    97.12%
    2/3/98   22 Pfizer        82.30    140.19    70.34%
   2/17/99   16 Yahoo Inc.   126.31    214.88    70.12%
   2/13/98   22 Intel         84.67    130.44    54.05%
   5/26/98   18 AmExpress    104.07    123.25    18.43%
   8/21/98   44 Schering-P    47.99     56.63    17.99%
    2/6/98   56 T. Rowe Pr    33.67     32.94    -2.18%
   2/27/98   27 Coca-Cola     69.11     59.81   -13.45%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     91.06    25.77%
   3/12/98   20 Exxon         64.34     72.69    12.98%
   3/12/98   15 Chevron       83.34     89.56     7.46%
   3/12/98   20 Eastman Ko    63.15     62.94    -0.33%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4515.00  $2636.55
   6/23/98   34 Cisco Syst  1985.95   3918.50  $1932.55
    5/1/98   55 Gap Inc.    1890.33   3726.25  $1835.92
   2/17/99   16 Yahoo Inc.  2020.95   3438.00  $1417.05
    2/3/98   22 Pfizer      1810.58   3084.13  $1273.55
   2/13/98   22 Intel       1862.83   2869.63  $1006.80
   8/21/98   44 Schering-P   2111.7   2491.50   $379.80
   5/26/98   18 AmExpress   1873.20   2218.50   $345.30
    2/6/98   56 T. Rowe Pr  1885.70   1844.50   -$41.20
   2/27/98   27 Coca-Cola   1865.89   1614.94  -$250.95

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1548.06   $317.17
   3/12/98   20 Exxon       1286.70   1453.75   $167.05
   3/12/98   15 Chevron     1250.14   1343.44    $93.30
   3/12/98   20 Eastman Ko  1262.95   1258.75    -$4.20

                              CASH    $185.03
                             TOTAL  $35509.97

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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