The Foolish Four Evolves

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Foolish Four Evolved

The Foolish Four has now gone through three versions, each better than the last in our NHFO (Never Humble Foolish Opinion). Each change has been a result of additional research and testing. Will we change again? You bet! IF we find a better method of selecting winners from our universe of 30 Dow Jones Industrial Average stocks.

What was wrong with the old methods?

Not a thing. Each is an improvement over the original Beating the Dow method popularized by Michael O'Higgins, and each is still "working." Each of these methods was developed by Fools working together on our message boards. Dozens of other strategies have been proposed and tested as well, especially since the release of our Spreadsheet of Dow price and dividend data. Many have have beaten Beating the Dow.

Those chosen as Foolish Four strategies went through months of being tested, discussed, and dissected inside out. Each proved to be superior to what we were using in terms of investment returns and lower risk, and each was reasonably simple (a big factor).

The original Foolish Four, sometimes known as OFF or 2,2,3,4,5, was described in the Fool's first book, The Motley Fool Investment Guide, published in January 1996. It was used to select Foolish Four model portfolio stocks for 1996 and 1997, and, in August of 1996, was used in the Fool Portfolio (now renamed the Rule Breaker Portfolio).

The Original Foolish Four is now designated Foolish 4.0, and a complete history of the origin of the strategy and its performance before and after its original publication can be read here: Foolish 4.0 . The gist of the strategy is that by dropping the lowest priced (#1) of O'Higgins's Beating the Dow 5 stocks, and doubling up on the second-lowest priced (#2) stock, one could beat Beating the Dow by several percentage points per year.

The first change in strategy was announced in December 1997 when You Have More Than You Think and The Motley Fool Investment Workbook were published. This version was originally known as the UV (Unemotional Value) strategy. It was used in the Foolish Four model portfolio in 1998 and in the Fool Portfolio (now the Rule Breaker Portfolio) in February 1998. (The 1996 Foolish 4.0 stocks were held by the Fool Portfolio for 18 months because of the thankfully short-lived 18-month holding requirement to qualify for lower long-term capital gains taxes.)

Now known as Foolish 4.1, you can read its detailed history by clicking the link. In brief, its advantage was that by dropping the first stock selectively, it achieved returns comparable to the original formula (which always dropped the first stock), without the added risk of doubling up on the second stock. Similar returns with less risk. A good combination.

Our third variation started life as the RP or ER variation. This strategy dispensed with the somewhat arbitrary sort-by-yield, sort-by-price method that O'Higgins used in Beating the Dow.. Instead, a simple mathematical ratio that related price and yield is used to select stocks. The RP variation was first used by the Cash-King Portfolio (now renamed the Rule Maker portfolio) in March 1998 and is the basis of the first real-money Foolish Four portfolio begun in December 1998. The RP variation is now known as Foolish 4.2 .

Next year?

Who knows? Before changing for the second time we asked ourselves if somehow these annual changes could adversely affect the portfolio returns. After all, we constantly remind readers that following the strategy consistently for 5 to 10 years is the only way one can reasonably expect to see average returns like those from our backtested models. Are we somehow jinxing things by switching?

The consensus of the statistical wizzes we consulted was: Nope. While making individual decisions to include or exclude a stock (Philip Morris inspires a lot of discussion along this line!) will change one's investment returns in an unpredictable way, modifying a strategy, even every single year, should not affect the returns adversely as long, of course, as the modifications were backtested alongside the original strategy using the same methodology and data -- and proved superior. In other words, messing with the strategy may not be a good idea, but improving it is just fine.

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