<FOOLISH FOUR PORTFOLIO>
Just what is it?
RESTON, VA (August 30, 1999) -- The Foolish Four is often referred to as a "mechanical" investing strategy. As so often happens, once a phrase enters our personal lexicon and becomes familiar, we start thinking that it is obvious to everyone else. So today I want to backtrack a bit and ask: Just what is mechanical investing?
As the name implies, mechanical investing is not a very artistic endeavor. If you don't mind a mixed metaphor, you can call it cookbook investing. You follow the recipe and, hopefully, out pops a nice annualized return. Here's the Foolish Four Recipe:
1. Calculate the RP ratio for each Dow stock by dividing its current dividend yield by the square root of its most recent price.
2. Rank the 30 Dow stocks by the RP ratio, highest to lowest. Eliminate the stock with the highest RP and buy the next four stocks.
3. Hold the stocks for one year (a year and a day if you are subject to capital gains taxes).
4. Repeat Steps 1-3.
We have a few flourishes that embellish the recipe. We've found that, over the long run, the returns have been highest for portfolios that have been renewed in late December. We recommend that, while you can start at any time, you should renew your first portfolio early if you don't have to worry about taxes, or late to make sure you have held for more than a year and qualify for long-term capital gains treatment.
Variations in the recipe allow investing in just the top two stocks, for slightly higher but more volatile returns, or adding a fifth stock for slightly lower but more stable returns.
The "recipe" is what makes the Foolish Four a mechanical investing strategy. It's very different from other kinds of investing, even other Foolish strategies. We don't analyze projected earnings, read financial statements, calculate the price-to-earnings ratio, check out the competition, worry about debt loads, or any of the usual things that go into stock investing. Instead, we use a few simple parameters that have been shown, over decades of backtesting, to identify stocks that will do well over the next year or two. In the case of the Foolish Four, there are only three parameters: membership in the Dow, the current yield, and the current price.
The other thing that separates mechanical investing from other kinds of investing is discipline. Almost any experienced investor will tell you that finding good stocks is easy; the hard part is knowing when to sell. With mechanical investing, the selling part is built right in. You review your portfolio at a set time and remove any stock that no longer meets the criteria.
A couple of months ago, a reader wrote to me about the relief he found when he switched to the Foolish Four after years of picking his own stocks. At last, he was free from the feeling that he should be continuously reevaluating his portfolio, wondering if it was time to sell this stock or the other, wondering if he should sell this one to buy that one.
That's the beauty of a mechanical strategy. You have to spend some time selecting a strategy and understanding it thoroughly, but once you commit to the strategy, the process of buying and selling goes on autopilot.
Thursday we will talk about other kinds of mechanical investing strategies, and what to do when you just can't stand to follow the rules.