Post of the Day
April 28, 1998

From our
DDA/Foolish 4 Board

Subject: Heresy!
Author: fredochs

Hello All You Fools:

After writing a recent post "a little tid-bit"

I began to wonder whether the Foolish 4 variants (old Fool4, UV4, RP4, etc.) really do beat an S&P500 index fund. So I decided to run some numbers. For simplicity, I chose to compare VFINX (the Vanguard S&P500 index fund) with the old Fool4.

There are quite a few problems with comparing the two approaches, as most of you are aware:

First, there's just finding the data. I could only find annual return data of VFINX back to 1986 (returns *with* dividends reinvested; more on this below), and I couldn't compare the average return of that period (1986-1997) to that of the Fool4 for a different period (like 1975-1996, posted by Timberfool). (Rayvt, you've posted data that I could use, right? I can't find it.) I did find annual data for one BTD method (old Fool4) in the Motley Fool web site, so I just used that. To determine CAGRs of each, I used the geometric mean of returns for 1986-1997. The Fool4 average return is 20.9%; the VFINX average return is 16.7%.

Second, there's this darned tax issue. Figuring out what the "effective" tax is on a Fool4 is not especially simple (see , and my "reply" message following this one). What taxes must be paid and when can drastically affect returns. I took a stab at it, explained below.

Third, there's commissions on the stock transactions ($7 - $12/ transaction). I'm just going to skip this completely, as with a larger account ($10,000), the effect is small (< 0.5%).

Finally, there's dividends. All CAGRs posted for various BTD methods include dividends as part of the return. However, the returns posted *do not* have the dividends gaining interest throughout the year, nor are they reinvested in more BTD stocks. For mutual fund returns, dividends *are* gaining "interest" by being reinvested into more fund stock. I don't have the raw Dow data, so there's not much I can do about correcting the "reinvestment problem" for the BTD methods, so I'll just wave my arms and say that the interest the dividends would be getting cancels out the commission fees. (Not that I believe this for a second, but there it is. If any one of the Great Number Crunchers(tm) with the TBD or some other database could provide us with returns adjusted for interest on dividends, I will correct this flaw.)

So, what did I do? I took the following scenario: Take two accounts, each worth $10,000: in one, follow the (old) Fool4, reinvesting dividends only when the portfolio is turned over (start port January 1st, hold 12 months, re-balance); in the other buy into VFINX, and reinvest the dividends quarterly. After 10 years, look at the results.

I also had each portfolio pay taxes. (This is the important part.) The Fool4 port has to pay taxes in full, each year. For its dividends, it pays taxes. For its capital gains, it pays taxes. This money is not free to earn interest. The VFINX port OTOH, only pays taxes on distributions each year (dividends and realized Cap gains); the rest of the cap gains are not taxed until withdrawal, and continue to "earn interest". This isn't some special strategy; it's just the law. For VFINX, the distributions are low, about 30% of returns, so the rest of the profit is sitting there compounding. (Note: I used the 28% income tax bracket.)

So for a ten year period, the Fool4 port is paying 21.7% "effective" tax per year, and the VFINX port is paying 8.4% "effective" tax per year. (I'll show how I calculated the "effective" tax in a reply to this message; otherwise this message is _way_ too huge.) At the end of the ten year period, all of the money is withdrawn, which means all gains are taxed. The "end effective tax" for the Fool4 port is 26.6% and for the VFINX port is 20.8%. (The Fool4 port tax is higher because there is no carryover of a stock still in the Fool4 listing; the VFINX tax is mostly long-term cap gains tax, because most gains have been held for over 18 months.) Clear as mud? Let's move on.

So what are the results? Here they are:

start with $10,000, end after 10 years with:

VFINX: $35,363 (calculated return: 13.5%)
Fool4: $45,086 (calculated return: 16.3%)
Dow30: $40,501 (calculated return: 15.0%

(I threw in the Dow30 method, treated roughly the same as the Fool4 for tax purposes, just to see how things compared. It was also started in January, held for 12 months, and re- balanced, once a year for 10 years.)

At first glance, it appears that the Fool4 wins, and wins handily by 3%. As elann and others have pointed out, that's quite a bit. So, go with the Fool4 (or your favorite BTD method), and fool on, right?

Well . . . . ;^)

If you all remember, there's this silly thing called the "January effect". If you look at the quarterly data by Timberfool or the monthly data by TMFSandy, you see that Portfolios staring in January are *much* better than those started in other months. That's why I picked a 12 month hold, starting in January. It's the best time to buy and the perfect period to hold (18 month holds are not as good as 12 month, if started on January 1st). All the rest are less.

How much less?

Oh, about 2 to 3%.

Hmmm, you say, the Fool4 I just showed you only beats VFINX by 3%.

Uhhhh . . . .

In other words: BTD methods started in any other time may
*NOT* beat an index mutual fund, like VFINX.


A few additional notes:

  • If we look at longer time periods, the difference between Fool4 and VFINX gets smaller. After 20 years, the difference is 2.2%, after 30 years the after-tax difference is only 1.8%.
  • As the Fool4 gets more popular (especially with Trusts and their Billions getting into the act), the Fool4 return could decrease, which will make the difference between Fool4 and VFINX smaller.
  • This simulation was done for the 28% tax bracket; if you're in a higher tax bracket (lucky dog!:^), the difference between Fool4 and VFINX after tax is even smaller.
  • The Fool4 has to beat VFINX by 1% in pre-tax returns just to break *even* after-tax. The "amount-needed-to- break-even" increases with the time horizon, i.e. after 20 years the Fool4 has to beat VFINX by 1.4% pre-tax return just to break even after tax.

So in other words, a Fool4 port started in March, say, and rebalanced every 18 months, will probably lose to VFINX after about 20 years.

Now, before y'all flame me for being a Heretic, let me say just a few more words. First, I've invested in a Fool4 variant, and I intend on continuing the practice. (For one, I'm in a low tax bracket, so the Fool4 wins by more on average.) Second, for this simulation I've used *average* _past_ returns. No one should expect to get the average return in any given year, and we have *no idea* what the future returns could be. Maybe for the next decade the Fool4 variants will beat VFINX by +5% (or maybe it looses by 5%!); we just don't know. And finally, if your Fool4 variant is in an IRA, you'll *probably* be ahead of VFINX no matter what month you start; after all, it's the tax consequences that kill the Fool4.

Here's at least one way I think all this info is useful: to debunk the "Dow Dozens" type approach, of buying the top BTD stock each month. We've all seen the post by newbies asking what to do with a little extra money each month. TMFSheard would say, "Try my Dozens approach!". I'd say that would be very un-Foolish. Having 12 rolling portfolios would dilute the returns, and after 10 years or so would *LOSE* to VFINX (or an equivalent index fund). A better idea would be to have an index fund *and* a January start, 12 month hold Fool4 variant. During the year put money in the index fund, and every few years at the appropriate time take money out of the index fund and put it into your Fool4. I'd bet a 12 pack of Your Favorite Beverage that my approach beats the Dozens or any other "rolling"-type approach.

just foolin',


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