The Fool FAQ

What is the Foolish Four?

The Fool FAQ

What is the Foolish Four?

Originally the Fool recommended following an investment method developed by Michael O'Higgins in his book Beating the Dow in which you identify the ten Dow stocks with the highest dividend yields (the High Yield 10 AKA the Dogs of the Dow) and, from those, buy equal dollar amount of the 5 lowest-priced stocks and hold them for one year. After one year, you repeat the process again. This simple approach, which takes all of 15 minutes per year, returned 19.67% per year from 1971 through 1996 versus the Dow 30's 13.30% over the same period.

The Foolish Four was developed by readers of the Motley Fool. It increases the returns by using a more sophisticated way of picking the stocks.

The basic Foolish Four method starts with a list of ten highest yielding Dow stocks (the High Yield 10), ranked by price lowest to highest. If the lowest priced stocks is also the highest yielding stock, it is dropped from the list. (Analysis of the data showed that when a stock was both the lowest priced and highest yielding Dow stock, prospects for the coming year were pretty grim.) The four lowest priced stocks (excluding the lowest priced if it is being dropped) are purchased in equal dollar amounts and held for one year (a year and a day in taxable accounts). This strategy has achieved an annual average return (CAGR) of 22% over the past 25 years.

Readers of the Motley Fool Investment Guide, please note: The method outlined in that earlier book called for always dropping the lowest priced stock and doubling up on the second lowest priced stock. Further research has found that the returns for that strategy and the one described above are virtually identical, but the newer approach is less volatile.

The RP variation (sometimes known as the ERP) was developed by our readers on the Dow Dividend Approach / Foolish Four message board. This strategy uses a different kind of formula that gives more weight to the yield. Stocks are ranked according to the ratio between the yield squared and the price using the following formula:

Yield x Yield = RP

The RP ratio is calculated for all 30 Dow stocks. The stocks are ranked by RP, highest first, and the top (highest ratio) stock is eliminated. The next four stocks are purchased in equal dollar amounts. This method has beaten the Foolish Four fairly frequently over the last 25 years. The 25 year average annual return is 24.5%.

Should I have the dividends reinvested?

It's probably easiest just to let the dividends accrue in your brokerage cash account until you make your annual portfolio adjustment. The returns for the model portfolio (and the Dow history) assume that dividends sit idle until the annual adjustment. Of course, when your portfolio gets really, really big and those dividends are real money, it might be worth while to reinvest them. Just watch out for short term capital gains if you sell them at the end of the year with the other shares.

Does it matter when during the year I begin Beating the Dow?

Until recently most of the backtested modeling we have done assumes a January 1 start date so most of our quoted returns are based on a January portfolio. When we looked at various starting times, we found that portfolios that started in December or January significantly outperformed other starting times. We recommend starting in the last half of December or no later than January 2 (or the first trading day of the year).

If you want to start at any other time, that's fine, but if you don't do well at first or if you are subject to capital gains taxes, you might want to hold your first portfolio through the end of the year you start and all the way until the end of the following year.

If you are investing in a retirement account where capital gains taxes do not apply, you can update your portfolio every year on the same date. If you are in a taxable account, you will need to hold for a year and a day, so you might want to start earlier in December to allow for a one day a year offset in the start date. Whenever you have a bad, or losing year, renew earlier and take the short term capital gain (or loss) to keep your portfolio renewal date from creeping past January 2.

I'd like to start a self-directed IRA. Is the Foolish Four a good strategy to use in an IRA?

It's an excellent idea. Since the Foolish Four strategy requires you to trade your stocks fairly frequently, holding them in an IRA or any kind of tax-advantaged retirement account, eliminates the hassle of holding for a year and a day in order to qualify for long term capital gains.

What do I do after one year? How do I rebalance the portfolio?

After holding the stocks one year (and one day in taxable accounts), you rebalance your portfolio as follows:

  1. Take the total dollar value of your portfolio including dividends and any cash you want to add and divide by 4. That will give you the target value for your new investment in each stock.
  2. Get your list of new stock to buy either from our website or by running the numbers yourself. You will probably find that one or two or sometimes, even three, stocks will be on the list for a second go-round. That's normal.
  3. Sell all of the stock that is being replaced. If the stocks that are staying on are above your target value by a significant amount ($500 or so) sell enough shares to bring them down to the general vicinity of the target value.
  4. If the stocks staying on for a second run are significantly below the target value, buy enough shares to bring them up to the target value (more or less) and divide the remaining cash among the new stocks. When you are deciding how many shares to buy, always round down and make sure that rounding down leaves enough cash in your account to cover commissions.

Don't get carried away with being totally balanced. It makes little sense to buy or sell 3 shares of a company you are keeping for a second year just to make the numbers look nice. We suggest "balancing" only to the extent that you can do so while keeping the commission cost below 2%. So if you are paying $10 per trade, you wouldn't bother to rebalance anything within $500 of the target value. Unless, of course, you just HAVE to have things balanced. :)

Where I can go to learn more about The Foolish Four?

Simple as pie! Just click right here and whoosh! Off you'll go to the area of the Motley Fool dedicated to the Dow Approach.