Mechanical Investing,
Part 3

Can't leave well enough alone?

By Ann Coleman (TMF AnnC)

RESTON, VA (Sept. 3, 1999) -- I must have received hundreds of e-mails over the past several years from folks asking if I thought they should modify the Foolish Four just a bit, either because they had an idea that might improve the returns, or they had a really bad feeling about one of the stocks. (Sears seems to be the prime candidate for that last question these days.)

There are two correct replies: Absolutely not, and, sure, why not?

A few paragraphs down, that might make sense.

The essence of mechanical investing, Motley Fool style, is that you follow a prescribed formula. That formula has been backtested over a number of years. (The formula isn't something that "just works," by the way. It has to be based on sound investing principles.) By backtesting a certain formula, we can see how a particular strategy would have worked in the past.

That is no guarantee of how it will work in the future, but it probably beats hot stock tips via e-mail.

So when people ask if they might be better off selling each stock as soon as it goes up 30%, but that idea has not been tested, there really is no answer. I just don't know -- and testing most of them is not an easy proposition. (Those that are easy to test have probably already been tested.) But I have complete sympathy with the urge to improve on "the system." That's where the Foolish Four came from in the first place.

One of the wonderful things about mechanical investing is the way that it seems to inspire people to come up with creative ideas. The downside is that unless an idea has been tested, and some are nearly impossible to test, there is absolutely no way to know whether it will be better or worse than the original strategy. A lot of ideas that sound good don't work out so well in practice.

So, the answer is no, don't mess with the system. You have no way to know how it will work out, and the odds are pretty good that it won't beat the Foolish Four. On the other hand, who am I to tell anyone what to do? We preach that people are responsible for their own investing decisions and if Joe Rolldice wants to come up with a system of his own, hey, maybe it will triple the market.

The path between these two extremes is our Fool Four message board. That's where new ideas can be debated, new strategies tested. At this point, many of the "new" ideas have already been debated and/or tested, and that information has been compiled by True Fool, Dave Goldman, in a Frequently Asked Questions post that he maintains purely out of the goodness of his heart. If you have an idea to improve on the Foolish Four, that's the place to start. It's also a grand place to get up to speed with what is happening on the message board without plowing through 25,000 posts.

For those who are strongly afflicted with the urge to mess with the system and who have a quantitative bent, we have the Foolish Workshop, a place where new screens -- less tested than the Foolish Four but very promising -- are constantly being discussed and tinkered with. The emphasis there is on thorough testing and statistical validation.

Whatever your inclination, though, there is one inescapable fact of life when it comes to mechanical investing: You should absolutely (and I mean it this time) never invest in a mechanical stock picking strategy unless you thoroughly understand the criteria it uses, how it picks stocks and why, how it has done over the past decade, and how it fits into your overall investing goals.

Absolutely positively.

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Foolish Four Portfolio

9/3/99 Closing Numbers
Ticker Company Dly Pr Chg Price
IPINTL PAPER15/16$50.50
JPMMORGAN (JP)7/8$133.81

  Day Week Month Year
To Date
Foolish Four 2.21% -1.45% 4.38% 27.55% 29.44% 44.93%
S&P 500(DA) 2.88% .66% 2.77% 10.99% 11.06% 16.27%
NASDAQ 3.98% 3.05% 3.79% 29.66% 30.87% 47.23%
DJIA (DA) 2.15% -.10% 2.28% 21.48% 21.73% 32.68%

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

Trade Date # Shares Ticker Cost Value LT $ Val Ch
  Cash: $80.43  
  Total: $5,177.75  

• 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.