Mechanical Investing,
Part 2

Taking emotions out of the picture

By Ann Coleman (TMF AnnC)

RESTON, VA (September 2, 1999) -- The Foolish Four isn't the only mechanical investing strategy we discuss here at the Fool. All of the Beating the Dow-spawned strategies are mechanical, and new ones are continuously being suggested.

The most recent suggestion was to look at the low-yielding Dow stocks. Surprisingly, the stocks at the opposite end of the Dow yield spectrum do rather well. These are the growth stocks of the Dow, the one's whose yield is low often because the cash they are generating is going back into the company to pay for more growth. But such a suggestion isn't a mechanical investing strategy until it has been backtested and codified.

Beating the S&P is also a mechanical strategy. In our Foolish Workshop, we have enough mechanical strategies to keep the critics busy for years.

The essence of mechanical investing is -- as Robert Sheard made so clear in his book The Unemotional Investor -- removing the twin demons of Fear and Greed from the investing equation. OK, OK, maybe it can't really be done as long as humans are making the decisions, but having a strictly defined strategy to follow, one that you understand thoroughly, can make it easier to sit tight when the bad times roll in.

Understanding the strategy thoroughly is the key. It's not enough to know the recipe, you have to know how the strategy has performed in the past so you will be prepared for the worst as well as the best. Here's a good example: How many of you investors in the Foolish Four are aware that it has lost as much as 22% in one year?

Yep, that's right. 1966. (And it was down almost 18% in 1990, which is much closer to home.) All of our cheerful talk about millions in the future shouldn't hide the risk of investing. If you invest long enough, not only are you likely to become rich, you will almost certainly experience one or more really terrible years -- years that will probably cause you to doubt the strategy, years that will shake many less-prepared investors out of it altogether.

I sometimes think that I harp on this point too much, but every new Foolish Four investor needs to study the following Web page very carefully:

It shows the performance of each stock that met the Foolish Four criteria since 1961. It shows that most of them did pretty well; some were amazing, and many were real duds. That's typical of a mechanical system -- it will never be perfect. It also shows that when the market as a whole is down, the Foolish Four can be down even further.

While that is true for many kinds of investing, especially those that tend to select outperforming stocks most of the time, one of the advantages of mechanical investing is that the strategy is testable. Given a historical database, one can go back in time and see exactly how the strategy would have performed under different market conditions -- without foreknowledge. To me, that ability is invaluable.

You can see exactly how that wonderful average return that you drool over actually occurred year by year. An average is nice, but knowing that the average temperature on earth is about 32 degrees Fahrenheit is not very useful for planning what to wear today. Investors who put their money into the Foolish Four expecting a 24% return that year are going to find themselves in the equivalent situation of a Southern California beach bum waking up at Baffin Bay one January day.

It's the unexpected that gets you.

Today's Stock Lists | 1999 Dow Returns

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Foolish Four Portfolio

9/2/99 Closing Numbers
Ticker Company Dly Pr Chg Price
IPINTL PAPER15/16$49.56
JPMMORGAN (JP)-3 11/16$125.94

  Day Week Month Year
To Date
Foolish Four .62% -3.59% 2.12% 24.79% 26.64% 40.63%
S&P 500(DA) -.89% -2.15% -.10% 7.89% 7.95% 11.68%
NASDAQ -.60% -.89% -.19% 24.70% 25.85% 39.37%
DJIA (DA) -.86% -2.20% .13% 18.93% 19.17% 28.82%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg

Trade Date # Shares Ticker Cost Value LT $ Val Ch
  Cash: $80.43  
  Total: $5,065.62  

• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

The Foolish Four Portfolio was launched on December 24, 1998, with $4,000. Additional cash is never added, all transactions are discussed and explained publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen once per year using a formula based on dividend yield and price. See The Foolish Four Explained for details.