<FOOLISH FOUR PORTFOLIO>

Risk and Reward 2
... and More on Standard Deviation

by Bob Price
([email protected])

Alexandria, VA (November 24, 1998) -- Yesterday we attempted to explain standard deviation in 500 words or less, and we discussed what it can tell you about risk. Today we'll take a look at the returns and standard deviations of our main strategies and some of their variations.

Remember we said that lower standard deviation indicates that the yearly returns are closer to the average return. So a lower standard deviation means less variability (volatility), which means less risk. When looking for consistent returns, the lower the standard deviation, the better. Of course, we also want those returns to be consistently high -- which won't happen.

It's a Wall Street truism that higher returns come only with increased risk. The trick is to get your higher returns with as little increased risk as possible.

In the table below, I have listed the variations in order of their standard deviations lowest to highest. All numbers are based on the annual returns for the past 25 years. "CAGR" is the compound annual growth rate, or "geometric average." (This is the proper "average return" for comparing how well strategies perform financially.) The "mean" is the arithmetic average. That's the average that the returns cluster around. The lower the standard deviation, the closer the mean and CAGR will be to each other and the closer the yearly returns will cluster around the mean. Our major strategies are in italics and major indices are underlined. Take a look and see if you notice anything special.

[Note: For year-to-date returns and a description of each strategy, see 1998 Dow Returns.]

Strategy    CAGR     Mean   Standard Dev.
HY10       17.69%   18.68%    15.64%
Foolish9   18.28%   19.32%    16.05%
RP9        18.14%   19.24%    16.51%
Dow30      13.83%   15.08%    16.93%
S&P500     13.06%   14.39%    17.12%
Foolish5   20.43%   21.82%    18.71%
RP5        22.24%   23.67%    19.08%
RP4        24.62%   26.05%    19.13%
BTD5       19.62%   21.07%    19.17%
BTD2-6     20.83%   22.41%    19.67%
HY5        18.60%   20.09%    19.89%
RP4+       25.23%   26.84%    20.55%
BTD4       22.13%   23.88%    21.25%
Foolish4   21.86%   23.63%    21.88%
Foolish4+  22.61%   24.67%    23.95%
RP2        26.24%   28.42%    24.37%
OFF        23.17%   25.48%    25.28%
Foolish2   23.71%   26.75%    28.63%
PPP        25.05%   31.43%    46.39%

Did you notice that, in general, the number of stocks in each strategy decreases as the standard deviation increases? Did you also notice the exceptions?

In general, the lower the number of stocks, the higher the standard deviation. This is true for most portfolios. If we just picked stocks randomly, the fewer stocks we picked, the higher the standard deviation of the group would be. Of course, these strategies are not random, but the same pattern holds.

What is surprising that there are three strategies -- High Yield 10, Foolish9 and RP9 -- which have lower standard deviations than the market. This is a remarkable result. Those three strategies also outperform the market by several percentage points a year. Higher return, lower volatility -- that's what we're looking for!

You might also have noticed that the RP4 is right in there with the 5 stock strategies. It outperforms them and has a lower standard deviation. Again, that's what we are looking for.

As you look down the table, you can see that the CAGRs also generally increase with increasing standard deviation. If they didn't, you wouldn't see the strategy here. That is, we don't consider a higher volatility strategy as valuable unless it rewards us with higher returns.

This chart also makes it clear why we moved to the new Foolish Four from the old one -- the Old Foolish Four has higher return, all right, but its higher standard deviation puts it down with the one and two stock plans. The OFF doubles the amount invested in the PPP. Check the PPP's standard deviation -- Yikes! (The PPP buys the second lowest priced stock on the High Yield 10 list. It is a one stock strategy proposed by Michael O'Higgins.) If you look at the other plans that double up on certain stocks (UV4+, RP4+) you'll see the same effect. They are more volatile than their base strategies, but they do give higher returns.

So one way to decide on a strategy might be to just run your eye down the CAGR list above looking for returns that are conspicuously higher than the next one down. Those are the strategies with a relatively high CAGRs for their standard deviations. That's kind of a seat of the pants way to do it, though. There must be a better way.

Next week, we'll take a Sharpe-er look at all this and come up with at least one way of ranking strategies that takes both returns and volatility into consideration.

In the mean time, Fool on!

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11/24/98 Close

Stock Change Last -------------------- UK + 1/16 44.81 IP -1 1/16 44.00 MO - 1/8 58.06 EK + 1/4 75.88

Day Month Year FOOL-4 -0.46% 5.50% 17.01% DJIA -0.78% 8.25% 17.61% S&P 500 -0.44% 7.67% 21.90% NASDAQ -0.58% 10.98% 25.19% Rec'd # Security In At Now Change 12/31/97 276 Philip Mor 45.25 58.06 28.31% 12/31/97 206 Eastman Ko 60.56 75.88 25.28% 12/31/97 291 Union Carb 42.94 44.81 4.37% 12/31/97 289 Int'l Pape 43.13 44.00 2.03% Rec'd # Security In At Value Change 12/31/97 276 Philip Mor 12489.00 16025.25 $3536.25 12/31/97 206 Eastman Ko 12475.88 15630.25 $3154.38 12/31/97 291 Union Carb 12494.81 13040.44 $545.63 12/31/97 289 Int'l Pape 12463.13 12716.00 $252.88 Dividends Paid YTD $1092.81 TOTAL $58504.75 </FOOLISH FOUR PORTFOLIO>