[Note: Last Monday's Rule Breaker column mentioned Human Genome Sciences' (Nasdaq: HGSI) privately held competitor, Seattle's ZymoGenetics. Catch our interview with CEO Bruce Carter.]

December is the coolest month. It's a time when the world -- or at least the world I know, the one that was mine when I formed my ideas about it -- becomes dark and cold and white and peaceful. The peace, together with the holidays that emerged from it, remind people of the things that have real meaning in their lives: roaring fires, family gatherings, smiling children, and... taxes.

For investors especially, it's important to think about taxes in December. It's the time to make any final buying or selling decisions that will impact your capital gains taxes for 2000. You need to have a good sense of the final numbers to make any necessary estimated tax payments in January. For more help on investment taxes, there is the pleasantly affordable Motley Fool Investment Tax Guide 2001. We'll also be having a tax seminar in February to help put things together. Keep your eyes peeled for details.

I'm thinking about taxes today, since we sold 900 shares of Excite@Home (Nasdaq: ATHM), as we announced last week, for $5 29/32 a stub plus an $8 commission. The portfolio numbers won't benefit from the capital loss that we'll realize in Excite@Home, just as it does not suffer from capital gains. We don't add or remove money from the portfolio to account for taxes.

The mutual fund industry also doesn't include tax losses in its reported returns. It's not unreasonable for it to do so. After all, many people hold funds in tax-advantaged accounts like Roth IRAs (bless them), which don't suffer from capital gains. Those who hold high-turnover mutual funds outside of tax-advantaged accounts, however, know the sting that tax time delivers unto them.

There are good reasons for us not to report after-tax returns as well. Our portfolio is often compared to mutual funds. In order to make that comparison balanced, we need to use the same conventions as they do. Since we have this apples-to-apples rule, we have made decisions to sell stocks without consideration of tax consequences. For example, were taxes a factor, we may not have sold America Online (NYSE: AOL) or Amazon.com (Nasdaq: AMZN) in 1998, almost all of the proceeds of which were capital gains. That makes it difficult to apply taxes on the portfolio ex post facto.

The main reason we don't report results after taxes is that it's just too complicated -- not to calculate, since that's being done, but to convey. The purpose of this portfolio is to educate (and amuse) about investing, not to delve into the intricacies of tax accounting.

In the spirit of Foolishness, however, I decided to take a rough guess at our portfolio's returns to date after taxes. Let me say right now that this is a back-of-the-envelope calculation. Rather than try to reconstruct exactly how taxes would have impacted subsequent purchases, I'm just going to figure out the amount owed in taxes, add that amount to our principal, and calculate the overall return. I'm also not going to mess with dividends, though they have had an impact. That would just be a nightmare.

For simplicity's sake, I'm going to pretend that the portfolio is mine (woo hoo!) and use my tax rate of 28% for short-term capital gains and long-term gains before May 1997 and 20% for long-term gains after May 1997. Gains from shorts, whatever the holding term, are taxed at 28%.

Here are the realized gains and presumptive taxes for each year since the inception of our portfolio:

Gain/(loss) Tax portfolio value

1995 $10,277 $2,878 $93,363

1996 18,665 5,226 133,441

1997 17,326 4,851 167,800

1998 60,280 12,226 501,851

1999 47,091 9,753 812,408

2000 (34,789) (8,074) 475,250 (YTD)

Total 118,885 26,871

A few notes: First, again, this is a rough calculation. It's not meant to represent exactly how much we would have paid in each year. For example, our capital loss in 2000 exceeds the $3000 limit on loss recognition in a year. In reality, we would have to carry $5,148 over into 2001, when it would offset long-term capital gains first rather than regular income, but for this model I have left it in its year at 20%. See what I mean by complicated? And I'm just approximating!

Second, notice that realized gains exceeded 10% of the portfolio's value through 1998. It was in December of that year that the Fool Portfolio became the Rule Breaker Portfolio. The evolution of the strategy has had the effect of reducing turnover quite substantially. Apart from the mechanical Foolish Four, there have been only four sales (and one short cover) in the past two years, including Excite@Home.

Now let's work out the overall return of the portfolio after taxes. To do that, as I said before, I'll just add the tax expenses to the original $50,000, as though it were money added in order to pay the taxes. That gives us a cost basis of $76,871 for the portfolio. Its value after the close on Friday was $475,250, for an overall return of 519%. That's a compound average growth rate (CAGR) of about 33% -- still well ahead of the overall market, but notably lower than the before-tax returns of 42%.

When you're deciding to invest in individual stocks or thinking about selling your winners outside of a tax-advantaged account, keep taxes in mind. When you trade in and out of stocks, you damage your returns. On the other hand, if you hold a bad stock too long, as we did with Excite@Home, you damage your returns even more. That's why index funds are the best investment choice for most people; they typically incur fewer current capital gains, involve no potentially bad choices, and allow your investment to compound relatively untaxed until the end of your investment period.

For those of you who still want to hunt for market-beating returns with a portion of your portfolio, consider enrolling in our second annual Quest for Rule Breakers 2001, which begins in January. We'll help you put our strategy in your investment quiver, and you'll help us build a list of ideas for future investments.

Happy holidays, one and all!

-- Brian Lund, TMF Tardior to the kind bank officials in the Cayman Islands.