FOOLISH FOUR PORTFOLIO

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What to Expect
from the Foolish Four

by Ann Coleman (TMF AnnC@aol.com)

Reston, VA (June 21, 1999) -- Expected returns. Today I found myself using that phrase from my Finance 301 days, and it got me to thinking about the way we quote returns for the Foolish Four. What should a Foolish Four investor really EXPECT from a multi-decade investment in the Foolish Four strategy?

In Finance 301, the term "expected returns" was used rather formally in the process of comparing various ways to invest capital. The idea was that you came up with your best guess (only you didn't call it a guess!) as to what various uses of capital could be expected to return, and then you compared that with the expected return from other investments.

How one calculates that expected return could be extremely complex, of course. Or it could be as simple as looking up what 10-year US Treasury bonds were paying at the moment. I always thought that those exercises needed some kind of fudge factor that let you say, well, I think this will return 15% per year, but it could be as low as 10% or as high as 20%. Maybe they saved that for the MBA program.

We often quote the most recent 25-year return of the Foolish Four. Right now, that would be the period from the beginning of 1973 through the end of 1998. Over that time period, the Foolish Four had an Average Annual Return of 24.5%. Should that be your expected return?

Short answer: No.

For one thing, the historical average return has been different for every 25-year period we've studied, and it has usually been lower. The average return varies with the market and, to a certain extent, with when you start and stop the study. For example, take a look at the table way down below. The worst 25-year period is the one that started in 1966 and ended in 1990. As it happens, 1966 was the absolute worst year for the strategy, and 1990 was the second worst.

Not only were they bad -- they were waaaaay badder than any other year. That particular 25-year time period got hit with a one-two punch. It happens. It could happen to you. But I wouldn't necessarily expect it to happen. On the other hand, returns for the last few periods have been well above the average. It's easy to see why -- we've been in quite a bull market.

Also, expected returns should take into consideration things like taxes and commissions. If you are investing within an IRA, taxes are not an issue until you take the money out (unless you are in a Roth, in which case, they are never an issue), and we have dealt with tax issues at length previously. Tax issues are too complex for any one-size-fits-all comparison, so I'm skipping that today. If you want to do a quick-and-dirty compensation for capital gains taxes, you can multiply the pre-tax average annual return by 0.8, though.

Since we haven't yet reached the point where brokers are paying us to make trades, you do need to consider the impact of commissions. As low as they have gotten, I've found that reducing the average annual return by about one half of a percentage point is a good rule of thumb as long as you are using a deep-discount broker. This will more than compensate not only for the out-of-pocket cost of commissions, but also for the economic impact of the commissions.

So, bottom line, what is a reasonable expected return for the Foolish Four strategy over a 25-year time span (given that it continues to work in the future as it has in the past)? Well, we have 14 overlapping 25-year time periods, covering a wide range of market conditions, in our database. The average of those average returns was 20.78%.

Therefore, my personal best guess is that you could reasonably expect an average annual return of around 20%, before taxes, over the next several decades. You will probably never get that return during a single year, of course, but as the years roll by and the returns roll in and the curve smoothes out, 20% is a reasonable expectation.

The average would likely be higher during strong market periods like we are in now, and lower when the market cools down, but I think 20% plus or minus a percentage point is a realistic expectation for a Foolish Four portfolio on a December or January renewal cycle over the next two decades. Not a guarantee, mind you, but a reasonable return to expect over the long term.

By the way, that is a phenomenal long-term return.

Twenty-Five-Year Rolling Returns, 1961-1985 through 1973-1998:

Ending
Year       Dow      S&P 500     Fool 4
1985      9.48%      9.56%     17.90%
1986      9.45%      9.26%     18.24%
1987     10.42%      9.89%     18.45%
1988     10.08%      9.67%     18.58%
1989     10.58%     10.20%     19.38%
1990      9.45%      9.54%     17.77%
1991     11.35%     11.19%     20.43%
1992     10.93%     10.56%     20.28%
1993     11.24%     10.52%     20.74%
1994     11.84%     10.97%     21.52%
1995     13.02%     12.21%     24.17%
1996     13.61%     12.55%     24.44%
1997     13.83%     13.06%     24.57%
1998     15.03%     14.93%     24.50%
Worst:    9.45%      9.26%     17.77%
Best:    15.03%     14.93%     24.57%
Fool on and prosper!

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06/21/99 Close
Stock  Change   Last
--------------------
CAT  -   5/8   60.88
JPM  +  13/16  135.94
MMM  -   3/4   90.25
IP   -  11/16  54.50



                  Day    Month   Year   History
         
        FOOL-4   -0.63%   6.01%  28.72%  30.63%
        DJIA     -0.36%   2.43%  18.59%  18.12%
        S&P 500  +0.45%   3.62%  10.32%  10.59%
        NASDAQ   +2.61%   6.47%  19.96%  21.60%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     60.88    41.31%
 12/24/98    9 JP Morgan    105.51    135.94    28.84%
 12/24/98   22 Int'l Paper   43.55     54.50    25.14%
 12/24/98   14 3M            73.57     90.25    22.67%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1461.00   $427.00
 12/24/98    9 JP Morgan    949.62   1223.44   $273.82
 12/24/98   22 Int'l Paper  958.12   1199.00   $240.88
 12/24/98   14 3M          1030.00   1263.50   $233.50

              Dividends Received      $49.99
                             Cash     $28.26
                            TOTAL   $5225.19