On to Other Things
Final words on Fool's Gold

by Ann Coleman (TMF AnnC)

Alexandria, VA (May 21, 1999) -- For the last two weeks we've been taking a hard look at the Foolish Four strategy, examining how it was developed, and answering some of the criticisms that have been raised about the strategy. I, for one, am not sorry to see this series draw to a close, but it has been a very useful process, and today I want to sum up what we have covered.

First, though, I want to be sure that everyone understands that while I believe that dire predictions of the Foolish Four's imminent demise are wrong, there is some validity to the concerns that critics have raised -- or at least some things to keep in mind.

Three major concerns have been raised about the validity of the Foolish Four.

First, it is a product of "data mining" and therefore invalid.

Second, even if the strategy does generate above-market returns, it is riskier and incurs more costs and taxes than a simple buy-and-hold strategy, therefore, once you adjust for risk, transaction costs, and taxes, it no longer outperforms the market.

Third, even if it still outperforms the market, its popularity will soon erase any advantages.

"Data mining" is often treated as serious charge, but it is nothing more than the process of searching for correlations in data. It is like fire -- extremely dangerous if used irresponsibly, but also extremely useful. I think that we have used the process in a useful and rational way. But I am also concerned about carrying that process too far as we attempt to improve our strategy. We need to stay on guard against the tendency to over-interpret data.

The second concern, about adjusting for risk, trading costs, and taxes, is one way that Efficient Market Theorists explain away anything that violates the sacred rule that no one can beat the market. Risk-adjusting a portfolio that is based on solid companies, such as those that make up the Dow, and then claiming that now it is no better than the market seems to me like hitching a racehorse to a beer wagon and then claiming he can't run any faster than a donkey.

Transaction costs have come down so dramatically that while they were once a significant factor, at this point anyone can (and should) easily keep transaction cost for the Foolish Four well below 1% per year after the first few years. With fixed commissions from a deep discount broker, that percentage will continuously drop as your account grows.

Taxes are something that really need to be considered for those who are investing outside their retirement account. Inside a retirement account, of course, the tax advantage of a buy-and-hold strategy all but disappears. But even when the Foolish Four has to kick in to keep the country running, it still beats a market-indexed strategy -- even if its return slip to the point where it is doing no better than the plain-vanilla High Yield 10 strategy.

The one thing that does concern me is the problem of popularity. So far, we see no evidence that the strategy is becoming so popular that an individual investor cannot profit from it. But there is some evidence that the Unit Investment Trusts put together by many brokerages to take advantage of the popularity of the High Yield Dow strategies are buying so heavily at the beginning of the year that they may be driving prices up. UITs have to follow certain protocols, though, such as buying the High Yield Dow stocks within the first few days of the year. So far, it looks like individual investors can take the side roads and avoid that rush by simply buying a few weeks before or after the crunch time.

Enough rationality! A nice, "emotional" response to the article we have been discussing appeared on our message board this week. I think I will just get out of the way and let Gary Grinaker of Bismarck, North Dakota, have the last word.

One thing (among many) that I didn't like about the "Fool's Gold" article was the lack of alternatives.

The past results may not be a perfect predictor of future performance, but past results are the best predictors we have to work with.

You are not just data mining. I'm positive that if faced by a change in the underlying theory, like if half the Dow companies would suddenly stop paying dividends, you'd be the first to admit that the old data just doesn't apply to the changed situation and come up with new unemotional strategies for investing.

I have to admit, risk is a risky thing that I just haven't emotionally understood.

Emotionally, I yearn for the old days when steady returns were guaranteed (of course I was 6 at the time, liked licking savings stamps, and didn't know a 2% guaranteed interest rate was pathetically low).

Investing long-term in the F4... contains a small amount of risk. However, avoiding risk by not investing at all (the non-risk alternative) creates the certainty of poor performance.

I'd rather have a solid investment strategy with the downside risk of being merely well off at retirement (compared to the expected very well off) than have the certainty of retiring poor.

Based on past performance, my odds of... outperforming the Dow between now and retirement are much, much higher than my odds of surviving to retirement -- and I feel pretty confident about living to a ripe old age.

Gary the PhotoPhool

Thanks, Gary.

Fool on and prosper!

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Foolish Four Portfolio Archives »  

Today's Stock Lists | 1999 Dow Returns

05/21/99 Close
Stock  Change   Last
CAT  +  11/16  59.63
JPM  -   5/8   138.69
MMM  -   1/2   88.94
IP   +   3/16  55.00
                Day   Month    Year   History
        FOOL-4   +0.15%  -0.81%  27.90%  29.80%
        DJIA     -0.34%   0.37%  18.33%  17.86%
        S&P 500  -0.64%  -0.37%   8.54%   8.80%
        NASDAQ   -0.84%  -0.87%  14.96%  16.54%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     59.63    38.41%
 12/24/98    9 JP Morgan    105.51    138.69    31.44%
 12/24/98   22 Int'l Paper   43.55     55.00    26.29%
 12/24/98   14 3M            73.57     88.94    20.89%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1431.00   $397.00
 12/24/98    9 JP Morgan    949.62   1248.19   $298.57
 12/24/98   22 Int'l Paper  958.12   1210.00   $251.88
 12/24/98   14 3M          1030.00   1245.13   $215.13

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5192.02