Statistically, the highest-ranked stocks for both the Foolish Four and Beating the S&P are dropped because it makes sense to leave out these potentially highly volatile companies even if it is not justified by statistical analysis.

By Ann Coleman (TMF AnnC)
September 1, 2000

Both the Foolish Four and the Beating the S&P strategies follow the peculiar practice of dropping the first stock on their respective lists. I say "peculiar" because it is a rather contra-intuitive practice as well as a misunderstood one. The strategy says to buy stocks with high yields and low prices, so we throw out the one with the highest yield and/or lowest price? How can that make sense?

Let's just review for a minute how we get that list of stocks over there on the right. We get it from Today's Stocks Lists. That's somewhat like saying that clean socks come from a drawer or that milk comes from the refrigerator. "Today's Stocks Lists" is also known as LiveCalc, our instantaneous Stock List Generator. I love LiveCalc. It saves us a ton of time, but we don't want to take for granted what it does. Like clean laundry, we need to appreciate the effort that goes into the process rather than just focusing on the results.

LiveCalc does our laundry for us by ranking the Dow or BSP30 stocks according to the rules set forth in F4 Explained. Our Foolish Four stocks are selected by the RP method. Each stock's yield is divided by the square root of the price. That gives us the RP ratio. (RP stands for Ratio Procedure, so, yes, RP ratio means Ratio Procedure ratio, but we can't help that.) The stocks are listed by their RP ratio, highest first.

BPS stocks can be ranked by their RP ratio as well, but the "official" BSP strategy uses an older ranking method where the 10 stocks with the highest yield are ranked by price, lowest price first. The results from both procedures are very similar. Both strategies always drop the highest-ranked stock.

Why? There are two answers to that. The first answer has changed somewhat over the years. Here's the short historical sketch: When the first Foolish Four was developed, we noticed that the stocks ranked number one had an average performance well below that of the Dow as a whole. (We were using 21 years worth of data that consisted of the stock's name, its rank, and its return for the year, nothing more.) We didn't know a whole lot about statistics at the time, but we did know that just dropping the first stock because it improved the historical results was not a legitimate reason for doing so.

Our bible at the time was Beating the Dow by Michael O'Higgins. (All we were trying to do was beat his Beating the Dow strategy, which is where the method of ranking the 10 highest-yielding stocks by price came from.) In BTD, O'Higgins mentioned in passing that the second-highest-ranked stock was the "Penultimate Profit Prospect." It had both a high yield and a low price, and tended to do better than the others. He explained that the lowest-priced stock, which you would think would be the best performer, tended to be a company in real financial trouble. (When I interviewed him last year during his book tour for Beating the Dow With Bonds, I asked him why he didn't just drop the first stock, like we did. He said, "I never thought of it." Not dropping it probably saved him from a certain amount of criticism by the statistically literate, though.)

With the rationale that too low a price could mean a stock was not just having a bad stretch, that it was really in trouble, we felt comfortable dropping the highest-ranked stock. But, never entirely comfortable. We've certainly taken considerable criticism about it. Not everyone buys that rationale.

However, as we have continued to add to our database, the additional data has justified that position and O'Higgins' original assumption, but not entirely in the way we expected. The same phenomenon was found in the Beating the S&P backtest, although with only 13 years, one could hardly call that definitive.

Then, with the development of our more extensive monthly database, we found cases where the number one stock did really well. In fact, the average performance of all number one stocks was about the same as that of the other Foolish Four stocks.

So, why didn't we include it? With almost 40 years of monthly data, one fact stood out. That first stock was highly volatile. It's still true that the highest-ranked stock is often a stock in trouble. Not always, though. In fact, sometimes it's a great stock. But, mostly it is a stock of extremes. The standard deviation for the number one stock is twice as high as that of the Foolish Four as a whole.

Since it averages about the same as the others, but carries more risk, we still think it's a good idea to drop it. That certainly saved us last year when Philip Morris <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %> was number one, but there will be times when that policy will cause us to pass up a really great performer. So, the first answer is: the stock is highly volatile.

But, the real reason we drop that first stock is not justified by statistical analysis. This is the part that I don't think the critics really appreciate. It's really just common sense. Dropping the number one stock essentially means you are substituting the fifth-ranked stock. Historically, their returns are about the same, but number five's returns are far more consistent. So, why not use it and save yourself the possible grief that comes from the occasional stock in real trouble?

That works for me.

Finally, while we're on the topic of dropping undesirables, don't forget to play Fool Survivior. Who will get booted first: Bill Gates? David Bowie? Maria Bartiromo? Raven the Chimp? Make your guesses and you could win $2000, a Handspring Visor, or another fabulous prize.

Fool on and prosper!