Farewell, Foolish Four

Tom and David Gardner explain why they are no longer advocating the Foolish Four. More extensive long-term studies completed by our staff show that the strategy hasn't beaten the market by as much as it did in our original 25-year sample. Over the past 50 years, Foolish Four outperformance was less than 2% annually. While still attractive, the approach is suspect in light of the recent changes in the Dow. The addition of non-dividend paying companies and a waning interest in dividend income have caused us to doubt that the strategy will consistently outperform the stock market's average in the future.

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By David Gardner and Tom Gardner
December 11, 2000

We've been writing about and advocating the Foolish Four strategy for six years, but after more extensive research and reflection, we want to let you, the Foolish Four community member, know that we are no longer going to advocate use of this strategy.

The decision comes as a result of a Foolish study conducted by Fool staffers Ann Coleman and Bob Price. They used an extensive 50-year database to test the premise that the Foolish Four formula can beat the market. Ann will be writing about the details later this week, but the bottom line is that this study -- the most extensive test ever conducted of the various high-yield/low-priced Dow strategies -- does not show enough outperformance to justify our continued championing of the Foolish Four strategy or any high-yield/low-price variation.

Notice we said that the study didn't find enough outperfomance. The results of the study were equivocal. Reasonable and impartial observers could look at this data and draw opposite conclusions about whether or not the high-yield/low-price approach "works." But regardless of whether or not it has outperformed by a small margin in the past, we don't have enough confidence today in its future. And given that we're coming up on a time of year when many Fools traditionally renew their Foolish Four portfolios, we wanted to let you know our thoughts now.

The Numbers
Let's look at the numbers. Although we do see moderately consistent outperformance over the last five decades, the Foolish Four's overall performance is not close to the magnitude that we had expected. Instead of almost doubling the Dow annually, as it had for a few recent decades, our 50-year study suggests the strategy has beaten the market over that long haul by just 1.74% annually.

Now, we must remind ourselves that the majority of mutual funds, thousands of them, have substantially underperformed that return. Still, in a taxable account, the Foolish Four's 50-year advantage is too small for us to justify its selection over a total-market index fund. Depending on the account size, that yearly 1.74% outperformance of the market average could get eaten away by transaction fees and capital-gains taxes.

Okay, so what about retirement accounts where taxes are not an issue? Here we shout out a resounding "maybe" when looking at the past performance. The near 2% annual edge over 50 years' time leads to a huge dollar advantage, admittedly. Ten thousand dollars invested at 11% annual returns becomes $1.8 million 50 years later, while that same amount invested at 12.74% annual returns becomes $4 million. Yet still, we cannot get away from our concerns that recent changes in the Dow have reduced the number of companies with significant dividend yields. Things look too different on the Dow today to confidently stand behind the past performance of the Foolish Four.

The New Dow
The Foolish Four depends on selecting from a sizeable pool of companies that pay attractive dividends. In the past, most of the Dow companies were paying dividends. Today, only about half of the Dow stocks are paying significant dividends. Why? Likely because tax law has made the double taxing of dividend income less attractive to investors in general. When a company earns money, it is taxed. When the company then pays a dividend to shareholders out of that earnings pile, the recipients are taxed. The double tax is an inefficient use of money. And we believe that these factors may undermine the strategy in the future and may, in fact, have already been affecting it for the last few years.

Given those doubts, we no longer believe that the Foolish Four will consistently outperform the market overall in the future. (We could be wrong about that too, of course.)

Our Conclusions
As you can see, our reflections do not substantially factor in the poor year the Foolish Four has had. No serious conclusions can be drawn about any investment strategy based on one or two years. Heck, bad years happen; any Foolish investor expects them. We assure you that even if this had been a great year, the results of our study and our concerns about dividends would lead us to these same conclusions

  1. In a taxable account, the Foolish Four's history shows little, if any, advantage over index funds or index shares.
  2. In retirement portfolios, the strategy could be useful, but we would only use it as the value component of a diversified portfolio.

In either case, the future performance of this dividend-based strategy will probably depend on attitudes toward dividends. Right now that trend is quite negative. We believe that negative trend will continue to be sustained (barring unforeseen alterations to present tax laws).

Okay, so what we can learn from this experience? Let's look at the good and the bad.

The Good
1. We believe that our original enthusiasm for the Foolish Four was justified, given the data available at the time. The Foolish Four was simply an improvement to the High Yield/Low Price approach described by Michael O'Higgins in his bestselling book, Beating the Dow (BTD). The BTD approach had beaten the market by a wide margin prior to publication of that book in 1990 for reasons we considered rational and repeatable. Indeed, the strategy once again almost doubled the Dow from 1991 through 1995. That looked pretty conclusive to us at the time.

2. We continued to gather additional data. In 1995, fellow Fool and outspoken Foolish Four skeptic Randy Befumo decided to test the Foolish Four by building his own database and pushing back the test period an additional 12 years. He also asked our own Bob Price to create a monthly database to see how the strategy performed when started in months other than January. We have since expanded the data as far back as 1950, and have gone on to look at how similar dividend-based strategies worked when not limited to a pool of Dow-only stocks. This sort of exhaustive research has not been completed anywhere else on the planet.

3. We have shared negative information about the Foolish Four with our readers as soon as we could. When a critical study was published by academicians Grant McQueen and Steven Thorley (Mining Fool's Gold), it was thoroughly discussed in this space. Although we weren't convinced by it, we did point our readers to it, and we encouraged discussion of the study on the discussion board.

4. Finally, we listened to you, our community. A small group of statistically literate Fools have been challenging us to defend the Foolish Four for over a year now. They are directly responsible for providing the incentive to get us to further explore the issue. Thanks, Fools.

The Bad
1. We took a long time to get our tests organized and done. The Fool's Gold article came out 18 months ago. Even before that there were warning signs as we expanded our database: The strategy essentially matched the market in the1960s, and the returns across all months were not as high as those for January.

2. We didn't allow enough consideration of what after-tax, after-fee returns would look like should the strategy prove to be only a mild outperformer. It was easy for us to rationalize that the 1960s were "ancient history" and not relevant enough to the present day (some will continue to argue this -- we will not). The fact that those test portfolios started in months other than January didn't perform nearly as well as the original January portfolios should have been a warning sign as well.

3. We loved the idea of a simple, safe strategy that anyone could use to beat the market. We fault ourselves for appreciating that simplicity too much -- at the expense of sufficient true value obtained by the practice of the strategy in taxable accounts. Likewise, while it does appear to have been a nice market outperformer over the past 50 years, we did not stress enough that should the makeup of the Dow Jones Industrials change, the modeling might likely as well.

The Future
So, as always, we're here to call'em as best as we can see 'em, in a constant and ongoing effort to help you make better financial decisions. As always, we wish we were perfect, that we never made any mistakes, and that the marketplace never changed (how simple life would be!). Alas, we are not. We've made plenty of mistakes (ahem, Sonic Solutions at $12, ATC Communications above $20, Gap during its expansion binge). And alas, we will certainly err in future.

Our solemn commitment to you is always to let you know all that we're learning from our successes and failures every step of the way, hoping you'll learn from both! Indeed, you can watch it all happen as we go. In fact, we're counting on you to participate in the shaping of superior approaches to money management. Literally, tens of thousands of Fools have played a role in the building, modifying, and now our moving away from The Foolish Four approach. We thank you.

The Foolish Four approach still has some attractive aspects to it. Again, it appears to be substantially more attractive than the vast majority of professionally-managed mutual funds. But our negative read of this more thoroughgoing, 50-year data, combined with our belief that dividends are becoming less au courant and do not as significantly factor into the Dow Jones Industrials anymore, means that we no longer advocate Foolish Four investing. We'll continue to monitor this strategy in our Mechanical Investing area, alongside the many other good and bad ideas that we as a community are constantly dreaming up, studying, trying, and learning from. Those that work provide profits. Those that do not provide lessons.

Thanks for reading to the end of our thoughts. If you have any, please share them. Fool on!

David and Tom Gardner

Read More Foolish Four Reports

Top Dow Stocks
( RP Order )


1. AT&T
2. * Philip Morris
3. * Eastman Kodak
4. * General Motors
5. * DuPont
6. Caterpillar
7. Int'l Paper
8. SBC Comm.
9. Alcoa
10. Procter & Gamble

NOTE: Today's Foolish Four stock selections are marked with an asterisk.

Foolish Four Portfolio

12/11/00 as of ~8:30:00 PM EST

Ticker Company Price
Daily Price
% Change
EKEASTMAN KODAK0.561.44%39.56
GMGENERAL MOTORS0.561.10%51.56
JPMMORGAN (JP)9.506.45%156.75

  Day Week Month Year
To Date
Foolish Four3.04%3.04%6.54%(14.12%)5.68%2.85%
S&P 500 (DA)0.75%0.75%4.94%(6.03%)12.92%6.37%
DJIA (DA)0.12%0.12%2.94%(6.61%)18.38%8.95%

Trade Date # Shares Ticker Cost/Share Price Total % Ret

Trade Date # Shares Ticker Total Cost Current Value Total Gain

• 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.