<THE FOOLISH FOUR>
When and How Long
by Ann Coleman
(TMF AnnC)
ALEXANDRIA, VA. (August 7, 1998) -- Two of the most frequently asked questions about the Foolish Four strategy have to do with the best time to start and how long to hold. Recently, our monster monthly database, compiled and tamed by Bob Price, was queried to provide some answers to these questions.
The most striking thing we found was that our monthly spreadsheet shows a decidedly seasonal bias. This was somewhat surprising since other researchers, especially Michael O'Higgins in Beating the Dow, had assumed that any random start date was as good as any other. But when we looked at the average annual return (Compound Annual Growth Rate) for portfolios that started at various times during the year, we found that this was not the case. Specifically, we looked at portfolios starting the first trading day of each month and holding for one year, renewing, and so on for 27 years. The statistical results were quite clear -- over time, the January 2 portfolio significantly outperformed all others, followed closely by December.
Here's how the numbers look for the Foolish Four strategy and the RP variation:
F4 RP4
Jan 22.04% 22.98%
Feb 16.23% 18.51%
Mar 16.15% 18.88%
Apr 15.59% 15.37%
May 16.22% 16.67%
Jun 16.59% 14.83%
Jul 13.56% 15.28%
Aug 15.62% 16.17%
Sep 16.55% 17.45%
Oct 16.77% 17.23%
Nov 16.76% 19.33%
Dec 18.53% 22.31%
It's not easy to do graphs in text, but for graphically minded folk, here is a visual representation (idea borrowed from Bob Price) where each asterisk represents one percentage point over 10%.
F4
Jan ************
Feb ******
Mar ******
Apr *****
May ******
Jun ******
Jul ***
Aug *****
Sep ******
Oct ******
Nov ******
Dec ********
RP4
Jan ************
Feb ********
Mar ********
Apr ****
May ******
Jun ****
Jul *****
Aug ******
Sep *******
Oct *******
Nov *********
Dec ************
Based on these results it sure looks like there is a decided advantage to starting, and renewing, in December or January. Please bear in mind, however, that this doesn't tell you anything at all about what will happen this year -- or next. A statistical average is no good for predicting short-term results. There were years when a July or August start date beat starting in January. But over time, it seems clear that the historical record suggests December or January as the optimal starting period.
I should also mention that the worst average return -- 13.56 for the Foolish Four renewing in July -- is not a bad return. It's about the same as the Standard & Poor's 500 Index or the Dow itself over that time period.
Why do I keep saying December or January? Why not just say January 2 is the day?
For investors who hold their Foolish Four stocks in a tax-advantaged account such as an IRA, it is clear that the first trading day of the year is the winner based on the data we have now. But for those who have to contend with capital gains taxes, the picture is a bit muddier. In order to qualify for the lower, long-term capital gains rate, it is essential that stocks be held for a year and a day. Obviously then, one cannot renew on the same day each year, and since returns drop off somewhat steeply towards February, it looks like starting sometime in the middle of December, then renewing a year and a day later each year, would be the best course.
Even so, eventually, the renewal date will start creeping into January (remember this is a long-term approach!). My suggestion would be to use the occasional bad year (and they will happen) to shift the renewal date up. For example, one year you may be looking at a very small gain or even a loss around the middle of December. Renew early and take a short term capital gain (or loss) to keep your renewal date in the neighborhood of Jan. 2.
But what do you do if you are ready to start NOW?
Obviously you want to optimize your potential returns. But do you need to wait until January to do that? What if you start now and then renew in January?
We looked at the results of starting each month from February to November and holding only until the end of the year. The average returns were OK, but the results were so varied that it appeared you had an equal chance of making or of losing money, and if you made money, you might have to pay taxes at the short-term capital gains rate! Hummm -- that's not particularly attractive.
Then we tried buying in months other than January and holding through the end of the current year all the way to the end of the following year. Ahhhh! Now we're getting somewhere. The results (on an annualized basis) were a bit lower than the average results for the strategy as a whole, but much more consistent. Again, the statistics don't say anything about what will happen this year or next, but of all the choices for starting at a time other than January, this strategy appears to be the most statistically attractive.
Our second most frequently asked question is how long one should hold. Congress's dance with the 18-month long-term capital gains law, since repealed in a moment of sanity, caused us to look closely at holding periods. For a while it appeared that an 18-19 month term was optimal for the Foolish Four strategy.
Several studies were reporting that holding for somewhere around 18-19 months provides a higher annualized return than holding for one year. There's an interesting story behind those studies. Studies looking at holding periods were conducted very thoroughly. The study would look at stocks purchased January 1, 19XX and held for 18 months, then at stocks purchased Feb. 1, 19XX and held for 18 months, then at stocks purchased in March, April, etc. throughout the entire time period of the data base. These studies showed that the highest returns were for holding periods of around 18-19 months, but the returns were lower than our yearly returns. Whoa! Big shock here at Fool HQ.
What was happening was that the seasonality effects overpowered the positive effects of holding for longer than one year. The bottom line is that while starting in January and holding for 18 months is a wonderful strategy, when averaged with the returns from other months, the overall return for an 18 month holding period starting randomly at any time during the year was much lower. Unfortunately, in a real world scenario, when one starts in January, holds for 18 months, then renews, the renewal takes place in July. Over time, the effect of renewing every other time in July negates the advantage of holding for 18 months.
So, what are the bottom line recommendations we can make from our examination of the monthly database?
1. Set up your portfolio to renew in late December or by the first trading day of the year.
2. Hold for one year. If you are in a taxable account, hold for a year and a day. When you have a bad year (and you will!) use that year as the time to back up your renewal date by a week or two to keep you in the December/January zone.
3. You can start the strategy at anytime, but hold your first portfolio through the end of the year and renew the following December/January.
[Robert Sheard is on vacation this week. He will return on August 10.]
Current Dow Order
| 1998 Dow Returns
[Robert Sheard is the author of the
The Unemotional
Investor (Simon & Schuster, 1998) available now at Amazon.com and
your local bookseller.]
08/07/98 Close
Stock Change Last
--------------------
UK + 5/8 47.81
IP + 5/8 43.25
MO - 1/4 43.00
EK + 9/16 83.56
|
Day Month Year
FOOL-4 +0.73% -1.30% 12.50%
DJIA +0.24% -3.21% 8.72%
S&P 500 -0.02% -2.79% 12.26%
NASDAQ +0.94% -1.37% 17.60%
Rec'd # Security In At Now Change
12/31/97 206 Eastman Ko 60.56 83.56 37.98%
12/31/97 291 Union Carb 42.94 47.81 11.35%
12/31/97 289 Int'l Pape 43.13 43.25 0.29%
12/31/97 276 Philip Mor 45.25 43.00 -4.97%
Rec'd # Security In At Value Change
12/31/97 206 Eastman Ko 12475.88 17213.88 $4738.00
12/31/97 291 Union Carb 12494.81 13913.44 $1418.63
12/31/97 289 Int'l Pape 12463.13 12499.25 $36.13
12/31/97 276 Philip Mor 12489.00 11868.00 -$621.00
CASH $754.73
TOTAL $56249.29
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