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Back in August I posted a chart showing the results of adjusting the
DJIA for the effects of inflation. That chart did not include the
effects of dividends or taxes in the calculation.
I recently was able to get data for the SP500 index including
dividend yield so I thought I would update the calculation to try and
include the other effects.
Inflation makes returns from a buy/hold strategy seem better than
they really are and capital gains taxes cause us to pay for inflated
gains with current dollars, increasing the effective tax rate. After
we have held an investment several years, we effectively lose 20% of
the proceeds (assuming a 20% capital gains tax rate) since the cost
basis will become very small due to inflation, even though the
CPI-adjusted cost is still quite high.
I back-adjusted the SP500 index for inflation using the Consumer
Price Index (CPI). I then assumed that we purchased one "share" of
the index at the CPI-adjusted price at the end of some year and then
sold it on 12/29/2000.
CPI-adjusted dividends received, less 28% for taxes, were reinvested
each year at the then current CPI-adjusted price to accumulate
additional "shares". Finally on 12/29/2000 we sold the all "shares"
and paid 20% capital gains taxes in today's dollars. (The cost basis
for tax purposes is the non-inflation-adjusted value of the SP500
index at the time of each investment since the cost basis is not
indexed with inflation.)
I realize that tax rates have varied over time so this is just an
approximation to illustrate the profitability of a buy/hold strategy.
The resulting after-tax and inflation values are plotted (in red) for
each year since 1871 on the attached chart. (SP_Adj1.gif) The best
fit trendline shows an average 2.67% real annual increase over the
past 130 years.
The CPI-adjusted SP500 index is also plotted (in blue) for
comparison. The best fit trendline shows an average 1.40% annual
increase over the 130 years.
The values assuming no taxes on the capital gains or dividends are
plotted (in green). The best fit trendline shows an average 2.92%
annual increase over the 130 years. This would be the performance
we would realize if we paid no taxes on our profits.
There seems to be a superimposed 30 year cycle about the regression
line and we are now near a peak in that cycle.
Obviously, the performance over the past 20 years has been unusually
good by this historical perspective. The second chart (SP_Adj2.gif)
shows the last 20 years in more detail. The best fit trendline shows
an average 10.5% real annual increase over this 20 year period.
The previous 20 years was fairly flat (SP_Adj3.gif) but with a lot of
volatility. During the two years from 1972 to 1974 the portfolio
value dropped half of it's real value because of both the poor stock
market and the high inflation rate.
I would guess that most proponents of a buy/hold strategy will be
surprised at how poor the after-tax returns actually have averaged
over the years.
The details of the calculations are shown below. I think they are
correct and will welcome comments and corrections.
Bob Fulks
----
The following illustrates the calculations assuming purchase at the
end of 1998 and at the end of 2000.
Data:
1998 1999 2000
CPI 163.90 168.30 174.50*
SP500 1229.23 1469.25 1320.30
SP500 CPI Adjusted 1308.73 1523.38 1320.30
SP500 Dividend % 1.34 1.14 1.14*
(* = Estimated)
Buy 1 share on 12/31/98
Cost at 1308.73 $1308.73
Basis at 1229.23 $1229.23
Dividend on 12/31/99 $17.37 (1.14% of $1523.38)
Less taxes of 28% 4.86
Net After Tax $12.51
Shares Purchased at 1523.38/sh 0.0082
Basis at 1469.25/sh $12.06
Total Shares owned 1.0082
Total Basis of shares $1241.29
Dividend on 12/31/00 $15.05 (1.14% of $1320.30)
Less taxes of 28% 4.21
Net After Tax $10.84
Shares Purchased at 1320.30/sh 0.0082
Basis at 1320.30/sh $10.84
Total Shares owned 1.0164
Total Basis of shares $1252.13
Sale of shares on 12/31/00 1341.95 1.0164 sh at 1320.30
Cap Gain (Proceeds less basis) 89.82
Cap Gains tax at 20% 17.96
Net after Cap Gain tax 1323.99
Ratio Proceeds to Cost / Proceeds 0.9885
Index value at 12/31/98 1305.08 = 1320.30 * 0.9885
This process is repeated for every year back to 1871.
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