Moving Targets
Picking the best Foolish Four

by Ann Coleman

Reston, VA (April 12, 1999) -- What a day! Even International Paper (NYSE: IP) rose better than 2 points... Maybe that puppy is finally waking up. After a brief scare last month, Caterpillar (NYSE: CAT) seems to be back on track, too.

Even though it is up 19% from the point at which we bought it, Caterpillar is still on the current Foolish Four list, although 3M (NYSE: MMM) had taken over the top spot yesterday. These two stocks have been on the Foolish Four list fairly consistently for many months, but the other two slots seem to be moving targets.

Because the RP formula that we use to select Foolish Four stocks is based on stock prices, it is almost inevitable that the stock rankings will skitter around like a drop of water on a hot skillet. Prices just do that. But there is much more consistency here than may meet the eye. What is mostly happening is that a core of 6 or 7 stocks are cycling in and out of the 4 stocks we list as the Foolish Four.

Even with that bit of consistency, this constant switching about is disconcerting to some people. I find it a bit disconcerting myself. One thing that several readers have suggested is that one might improve returns by buying some of the other stocks that are popping on and off the list. That's one of those things that seems intuitively obvious -- the only problem is that it doesn't work.

Our backtested database includes a 5-stock version of the Foolish Four, the RP 5, and we have tested larger portfolios as well. Each of these portfolios adds in one or more of the stocks that pop on and off the list. Our backtests show quite clearly that these larger portfolios have lower long-term returns. (This is not necessarily bad -- more about it in a minute.) Even with our older Foolish Four strategies and the High Yield strategy, including more stocks brings the average return down.

If you think about it, that's logical. If there is any validity to this method of stock selection, then the stocks that have more of whatever you are selecting for should do better. If yield is important, the five highest yielding stocks should outperform the 10 highest yielding stocks, and the highest yielding stock of all should outperform the five highest yielders. This is exactly what our database shows. In the same way, the RP 2 outperforms the Foolish Four, which outperforms the RP 5, which outperforms the RP 9, etc. The correlation is quite strong.

So here we sit on the horns of a dilemma (ouch!). On the one hand, we see that adding stocks to our portfolio is likely to hurt the returns. On the other hand, we see that the 4 stock portfolio changes almost daily, and the stocks you end up with appear to be at least partly a function of the day you pick to start. Something just doesn't feel right.

The answer is not particularly comforting, and it is a bit complicated, but I think it is true.

Yes, if you had bought yesterday, you would most likely have a slightly different list of stocks, and yes, yesterday's portfolio is going to end the year with a different return than today's portfolio, and yes, there is really no way to tell right now which will be the best choice, and yes, darn it, the obvious solution of buying more stocks doesn't really help.

The answer is, once again, to think long term. While the Foolish Four strategy is not strictly a long-term buy-and-hold strategy, since you are switching stocks every year, it has this much in common with LTBH philosophy: Worrying about optimizing returns over the short term is very likely to cause you to miss out on true long-term growth.

Although in any one year, buying additional stocks MIGHT increase your return, it might also lower it. Apparently, the risk of lowering your return by including additional stocks is greater than the possibility of increasing it because, over the long term, 5, 6 and 7, etc., stock portfolios have underperformed the Foolish Four.

As I said earlier, a lower return is not necessarily a bad thing. The returns don't just drop to the floor. In fact, the 5-stock version of the current Foolish Four has a Compound Average Growth Rate for the last 25 years of just over 21%, vs. 24% for the four stock version. But -- and this is the good part -- it also has a lower standard deviation, which makes it a good strategy for the more risk-averse among us.

Tomorrow -- an even better way to manage risk.

Call Your Boss a Fool.

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Foolish Four Portfolio Archives »  

Today's Stock Lists | 1999 Dow Returns

04/12/99 Close
Stock  Change   Last
CAT  +2  5/8   51.38
JPM  +   3/4   129.50
MMM  -   3/16  71.00
IP   +2  3/16  46.38
                Day   Month    Year   History
        FOOL-4   +2.66%   6.74%   9.77%  11.40%
        DJIA     +1.63%   5.65%  13.00%  12.55%
        S&P 500  +0.76%   5.62%  10.85%  11.11%
        NASDAQ   +0.22%   5.57%  18.52%  20.15%

    Rec'd   #  Security     In At       Now    Change

 12/24/98    9 JP Morgan    105.51    129.50    22.74%
 12/24/98   24 Caterpillar   43.08     51.38    19.25%
 12/24/98   22 Int'l Paper   43.55     46.38     6.49%
 12/24/98   14 3M            73.57     71.00    -3.49%

    Rec'd   #  Security     In At     Value    Change

 12/24/98    9 JP Morgan    949.62   1165.50   $215.88
 12/24/98   24 Caterpillar 1034.00   1233.00   $199.00
 12/24/98   22 Int'l Paper  958.12   1020.25    $62.13
 12/24/98   14 3M          1030.00    994.00   -$36.00

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4456.05