Foolish Four Portfolio
By
Getting Started
How much do I need to start?
RESTON, VA (Oct. 4, 1999) -- I guess we've done a pretty good job of convincing people that the Foolish Four is a good place to start investing. We get questions about how much cash you need to get started all the time! The strategy is simple, requires little training in finance, and is relatively safe.
Since this is an "entry level" strategy, let's talk about the entry level. Just how much money do you really need to start the strategy?
I'll get to that, but first, a word from our sponsor.
Foolish investing means that FIRST, you get your financial house in order. That means paying off all credit card debt, establishing a regular program of savings, and building your rainy day fund up to the point where you can weather the likely and some of the unlikely storms life sends your way. For some people, that may be a few months of basic expenses; for others, the self-employed especially, that may be six to 12 months' income in an easily accessible account.
It means making sure you have adequate insurance and that necessary debt like your mortgage, student loans, or car loans have been renegotiated to get the best rate. It means maxing out any retirement options offered by your employer, then maxing out individual retirement options like IRAs, SEP-IRAs, Keoghs, whatever you may qualify for. For those who can afford it and/or who want to retire early, it means going beyond the IRA to a brokerage account.
Only after you get to the point in that process above where you start an IRA does the question of "How much do I need to get started?" actually come up. Before that point, you're just getting ready to get started.
Now back to our regularly scheduled program.
The minimum for investing in a Foolish Four or any Dow strategy has been coming down as discount brokers and the efficiencies of online trading have driven commissions to almost unbelievably low levels.
The only real consideration is that commissions need to be kept small enough that they don't eat into your returns so much that you would have been better off in a no-load index fund. Generally, you are safe if you keep your annual commissions below 2% of your principal. That's a nice rule of thumb, but let's explore exactly what it means.
Say you've found a broker who charges $8 per trade and has a very low minimum. A $400 purchase would cost you $8 which is 2% of your principal. That's a pretty darn small stock purchase by most standards. Not so long ago it used to be unthinkable to invest in respectable stocks unless you could put at least $1,000 into each company. That may still be good advice, but I can't for the life of me think why. The only reason I've ever seen given has been "commissions," so it makes sense to me that as commissions come down, the minimum purchase amount should come down as well.
Although the minimum size of a single stock trade has come down with commissions, there is a very good reason for not jumping in with a slim purse -- diversification. For example, I would never suggest that anyone start their investing career by putting $400 into a single stock, even a Foolish Four stock. But four or five hundred dollars into each Foolish Four stock is actually less risky than putting the same amount of money into an index fund.
Really?
Well, it depends on your definition of risk. The Foolish Four is somewhat more volatile than the market as a whole, but much of that volatility is on the upside. That's good volatility. The Sharpe ratio is a method of risk assessment that integrates return and volatility, and by that measure, the Foolish Four beats an index fund hands down. In fact, the Foolish Four has the highest Sharpe ratio of any Dow strategy we've tested.
Because of the Sharpe ratio, I'm not reluctant to suggest the Foolish Four as a reasonable alternative to an index fund for beginning investors -- and it can actually be easier, or at least no more difficult, to set up.
True, most portfolio management theories would tell you that you need at least eight stocks in diversified industries to protect yourself from the dangers of underdiversification. But unless the Foolish Four deals you three of a kind (say, American Express <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AXP)") else Response.Write("(NYSE: AXP)") end if %>, Citigroup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: C)") else Response.Write("(NYSE: C)") end if %>, and JP Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %>, you will get a fair amount of diversification because the Dow itself is structured to be a diverse representation of American business.
If you are very risk-tolerant and have a long time horizon, it's even possible to start a Foolish Four portfolio with just two stocks. (Huh?) We have tested a Foolish Two strategy (aka the RP2) and, while it is far more volatile than the Foolish Four, it still looks pretty good.
Don't kid yourself into thinking that the RP2 is a diversified portfolio, but historically, it has done extremely well with compounded average annual returns about two percentage points higher than the Foolish Four (26.67% vs. 24.55%). The standard deviation (all numbers are for 1974-1998) for the RP2 is 24.10% vs. 19.17% for the Foolish Four and 16.22% for the S&P 500. (Smaller SD = less volatility.) But the RP2's Sharpe ratio of 91.67 compares rather well to the Foolish Four at 100.23 and the S&P 500 at only 56.00. So while the ride may be a bit bumpy, you get there quickly.
I consider it suitable only for risk-tolerant, young investors who have time on their side, but not much money. Oh, yeah... the strategy is to buy only the first two on the Foolish Four list (numbers 2 and 3 on the Top Ten list). The RP2 stocks in our current real-money portfolio are Caterpillar and J. P. Morgan.
So far we've only been talking about how much you need to make those first stock purchases. But the Foolish Four is an annual strategy. When you renew your portfolio after a year or so, you will be making twice as many trades. You will be selling your stocks and buying new ones. So if you are starting out small you need to also be saving -- saving enough so that next year you can add an equal amount of cash to your portfolio so that your next round of trades won't cost you 4%.
Here's the bottom line. It's possible to start a Dow Investing strategy with less than $1,000 if you have a reasonable tolerance for risk and if you have a broker with flat rate commissions of $10 or less. (Our Foolish Four portfolio broker is Ameritrade which has the required low commissions, but has a $2,000 minimum.) Otherwise, you'll need enough to buy all four stocks without spending more than 2% on commissions.
How do you find such a broker? Glad you asked. Click here: Discount Brokerage Center. We assembled a bunch of good advice and an extensive list of brokers. When you start to feel overwhelmed with choices, you can click over to the Discount Brokers message board to see what other Fools think.
Thursday -- what if you don't even have that much OR you want to make monthly contributions.
Fool on and prosper!