One-Upping the Wise

By Al Levit (TMF Early)

GLENDALE, CA (April 7, 1999) -- Yesterday, we looked at an illustration of the tax advantages of the Foolish buy-and-hold strategy. Unfortunately, the last time I checked, most of us Fools still have to pay taxes, so it's the after-tax returns that really matter. I haven't found anyone who would disagree with this point, but at the same time, it seems that almost every measure of investment performance is reported on a before-tax basis.

To really appreciate the detrimental effect of taxes, it helps to see how they impact one's reported investment performance results. Otherwise, it's all too easy to fall into Trading Terry's trap (say that three times fast!) of thinking that she was outperforming Foolish Freddie because her pretax returns were higher. Normally, here at The Fool, we'd write something about how the Wise always measure their performance before-tax, but I'm afraid that this is one particular disease that even we Fools have succumbed to -- at least, so far.

The Rule Maker port is rapidly approaching its first tax day. How should we account for its results -- before-tax or after-tax? Both sides offer some compelling arguments. Let's take a look.

In support of before-tax results:

1) We compare the Rule Maker portfolio's results to that of the market indices, particularly the S&P 500. These indices do not account for taxes, so comparing our after-tax results would understate our relative performance.

2) Everybody's tax situation is different. Plus, many of us invest in tax-deferred accounts (IRA, 401(k), etc.), which makes after-tax results less applicable.

In support of after-tax results:

1) Taxes are as much a cost of investing as the bid/ask spreads and commissions. Moreover, taxes tend to be a much greater expense than the spreads and commissions combined!

2) The real-money Rule Maker portfolio exists in a taxable account. As such, reporting after-tax results reflects our actual performance.

By now, it's clear that I favor accounting for taxes in the returns. Taxes are a big investing expense, and they should be accounted for just like we account for commissions and spreads. Moreover, the Rule Maker portfolio is probably the most tax efficient portfolio in Fooldom, and we should take credit for that in the posted returns.

(Fade in Jeopardy! music as the Rule Maker managers huddle and discuss the issue... okay, that's enough, fade it out -- quick!)

All right, the Rule Maker managers unanimously agree that we should report the portfolio's performance according to the after-tax returns. Just like you, we face commissions, spreads, and taxes. As such, we'll report our performance net of these very real costs. Therefore, on April 15, we'll deduct $114.94 for our 1998 taxes (due to dividends and capital gains on partial shares from splits), which represents a paltry 0.3% (or, 30 basis points for you finance types) of our portfolio's value. Uncle Sam shouldn't plan on getting much more than this in the years ahead, as we remain steadfastly committed to the buy-and-hold approach. (The Buy-and-Hold Apocalypse is a must-read series that details the advantages of this most Foolish approach to long-term investing.)

Once again, we Fools are one-upping the Wise!

Now that you know how we feel about the tax issue, let us know how you feel on the Rule Maker Strategy board.

Finally, Yahoo! (Nasdaq: YHOO) reported its Q1 earnings this afternoon, with the conference call will being webcast at 1:30 p.m. PST (thanks to new acquisition broadcast.com). The replay will be available at broadcast.com for two months. You can also call 800-633-8284 (access code: 11956159) for the conference call replay, available at approximately 3:30 p.m. PST for 24 hours. Listen in and then come and discuss it on our Rule Maker Companies board.

See ya tomorrow,