<FOOLISH FOUR PORTFOLIO>

Vagaries of the Foolish Four
What exactly is it we are doing here?

by Ann Coleman (TMF [email protected])

Alexandria, VA (February 23, 1999) -- Last night, the Rule Breaker portfolio announced their Foolish Four switch for the year. Good going, guys, but it sure brought on a raft of e-mail! Actually, I've been getting quite a few questions about the frequent changes in the Foolish Four list. There seems to be a good bit of confusion about just what exactly the Foolish Four is.

Is it the stocks we bought last December and are following in the Foolish Four Portfolio? Is it the Top RP Stocks listed here and to the right? Is it the stocks that the Rule Breaker Portfolio bought today?

The answer is D -- all, or any, of the above.

The confusion seems to stem from the fact that the list changes quite often. I am afraid I have to eat a bit of crow on that account. Last fall I opined as to how the RP variation should be more stable than the old rank-by-yield, rank-by-price method. The old method tended to have clusters of stocks with very similar yields all competing for the 10th spot on the high yield list. As yields changed from day to day, a stock might fluctuate from 10th place to 11th and back again. Once on the High Yield 10 list, the stock would appear on the Foolish Four list if its price was low enough. One day it might be ranked 10th by yield and be a Foolish Four stock, the next it might not even make the top 10 list, then the next day, if it squeezed back into the High Yield 10, it could be back on the Foolish Four list.

Well, that used to cause quite a bit of confusion. I thought that since the RP didn't have an arbitrary cut off, it would be less subject to changes, but, boy, was I wrong!

With the benefit of hindsight, it's easy to see why. The formula for the RP is actually subject to the effects of price twice. First, changes in price affect the yield (yield = dividend/price), then the yield is squared and divided by price (or the yield is divided by the square root of price, your choice) to get the RP rank. All of that dividing by price makes our list very sensitive to even small changes in relative price.

The big question, of course, is how important is it that the list changes so often? Well, it's is vitally important to your returns THIS year. Obviously, different baskets of stocks will perform differently, and if you can end up with a different basket of stocks simply because you picked a different day to invest, the day you pick ultimately determines your return for the year.

Before you start to hyperventilate at the thought of luck playing such a major role in your returns, consider this: These mechanical strategies are not supposed to pick the "best stocks" of the Dow. I've studied the 38 year history of the strategy, and I don't believe that there was a single year where any of these strategies picked the four best stocks on the Dow. In fact, in almost every year, there were several really outstanding stocks that were quite conspicuously absent from the any of the Foolish Four, or even the High Yield 10, lists.

The idea is not to pick the best stocks (which is probably impossible, so why bother trying?) The idea is to pick enough of the good stocks. That's all. It's a modest ambition that most pros would love to be able to achieve as consistently as the Foolish Four has.

If we could tell now which of the stocks that are "good enough" will be better than the others, we could adjust our strategy accordingly. But we can't, so we have to settle for good enough -- remembering that the Foolish Four's "good enough" has been good enough to beat the market over every 10-year period in the last 25 years.

Using our monthly database, we have backtested the strategy over 37 years. We started 12 different portfolios for each year. We found that while naturally the yearly returns varied depending on which stocks happened to be on the list on those twelve days, over time those differences averaged out. The best returns were for strategies selected in December and January and held for one year before renewing with the current list of stocks.

As we have said all along, this is a long-term strategy.

Another question has been, should I sell the stocks I bought last month (day, week) and buy the ones on the list now? NO! Please don't do that. Bad idea. Very, very bad, bad idea. You would just end up trading stocks frequently, increasing the profits of your brokerage but not your own net worth. Buy and HOLD. Give the stocks a time to turn around and run for a while.

Speaking of turning around and running, how 'bout that J.P. Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %>? Up 9% -- go, JP!

Fool on and prosper!

Today's Stock Lists | 1998 Dow Returns

02/23/99 Close
Stock  Change   Last
--------------------
CAT  +   7/16  46.94
JPM  +2  5/16  115.44
MMM  -  11/16  77.81
IP   -   1/8   43.06

                   Day   Month    Year   History
        FOOL-4   +0.45%   6.44%   4.21%   5.76%
        DJIA     -0.09%   1.98%   4.10%   3.69%
        S&P 500  -0.08%  -0.66%   3.73%   3.98%
        NASDAQ   +1.47%  -5.17%   8.38%   9.86%

    Rec'd   #  Security     In At       Now    Change

 12/24/98    9 JP Morgan    105.51    115.44     9.41%
 12/24/98   24 Caterpillar   43.08     46.94     8.95%
 12/24/98   14 3M            73.57     77.81     5.77%
 12/24/98   22 Int'l Paper   43.55     43.06    -1.12%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1126.50    $92.50
 12/24/98    9 JP Morgan    949.62   1038.94    $89.32
 12/24/98   14 3M          1030.00   1089.38    $59.38
 12/24/98   22 Int'l Paper  958.12    947.38   -$10.75


                             Cash     $28.26
                            TOTAL   $4230.45

</FOOLISH FOUR PORTFOLIO>