Modifying Mechanical Strategies

Just how bad is it to modify a mechanical strategy if it picks a stock that you are just not willing to own? When you modify a strategy you risk dropping the very stock that makes the strategy a winner, but the odds are pretty good that you will just be dropping an average or below-average performer.

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By Ann Coleman (TMF AnnC)
December 28, 2000

We're coming down to the wire. There are only two Foolish Four columns left before the Foolish Four merges with the Workshop permanently, so, with apologies to those of you who are looking for something interesting to read, today and tomorrow will be devoted to settling some final details and answering some of the questions I've been getting about the Foolish Four and What To Do Now.

The big question is what to do about Philip Morris (NYSE: MO). Darn. It was stuck in first place for most of the last year which meant we skipped it and skipped the controversy. Unfortunately, MO has almost doubled in price in the last few months while Kodak (NYSE: EK) has been cut in half. They've switched places and MO is back on the Foolish Four list.

The Foolish Four strategy, as it is defined right now, skips the first stock on the list. That rule had the unintended, but very convenient, consequence of allowing us to avoid dealing with Philip Morris. It's been almost a year since I had to wade through hundreds of emails from people who are either appalled that I would even consider buying a "merchant of death," or are incensed that I am anti-tobacco and therefore anti-capitalism, anti-free enterprise, and anti-American. Since I am on the fence (I mean, objective and non-dogmatic), I get it from both sides.

Please, folks, spare me. I've read all the arguments and have come to one firm conclusion: The extremists on both sides need to get a grip. When a topic has been as thoroughly debated as this one has, it is unlikely that spouting the same arguments or, worse, attacking someone's character or calling them names, will induce a change of heart in anyone. Thank you.

Let's stick to practicalities. What do you do when a mechanical investing strategy selects a stock, any stock, that you have a strong personal aversion to? There are two schools of thought. The purists suggest that you simply ignore the specific companies and follow the strategy absolutely. But if you could do that, you wouldn't be agonizing over FursRUs (Ticker: PURR). The other school says, ya gotta do what ya gotta do.

So, how terrible is it to modify a mechanical strategy? That's impossible to say for any specific case, but honestly, these strategies are not perfect. They don't pick all winning stocks. They play the odds. A strategy simply screens the Value Line database for stocks that have high values for certain criteria such as market cap, earnings estimates, growth rates, etc. Usually we then sort the screen by recent return (also known as relative strength) and, of course, we test it. The idea is to find a basket of stocks that have a better-than-average chance to beat the market. Some will win big, others will lose money. Dropping one of them will alter your returns, but not necessarily for the worse.

You do run the risk that you might drop the big winner. Last year (1999) anyone who had ethical misgivings about Qualcomm (Nasdaq: QCOM) or JDS Uniphase (Nasdaq: JDSU) might have bitterly regretted their moral opposition to cellular technology or fiber optics. But the same odds that picked those stocks and a few other big winners, also picked a number of average companies and some outright duds.

Dropping one of the average companies or a dud is not a problem. Dropping the big winner is, and you can't tell which is which in the beginning. Still, the odds are in your favor that the stock you drop is more likely to be an average or below-average performer. That's if you are only dropping one stock occasionally. If you find you want to drop more than one stock per strategy, you would probably be better off following a socially responsible strategy of some kind. Mechanical strategies can probably stand a little bit of modifying, but start changing them often or a lot and you won't have a mechanical strategy at all. Bottom line: It is always your decision, but I see nothing wrong with modifying a strategy slightly on ethical grounds, as long as you understand the risks.

If you want to skip a stock, you can either skip it outright, buying only four of the top five stocks, for example, or you can replace it with the next stock lower down on the list. Say FursRUs is number three, and you wanted a five-stock portfolio, you would simply replace PURR with the sixth stock. Foolish Four investors could replace MO with either the number one stock on the list or number six. Our new, far more extensive study shows that the number one stock is not the investing pariah that we once thought it was, so feel free to use it if you like.

Now on to the question of when we are going to renew the Foolish Four portfolio. Normally we would be making our Foolish Four trades for the year right about now, but since the Foolish Four is moving into the Workshop Portfolio when it starts next week, we've decided to hold off on until January 8, at which time we will set up the portfolio for the entire year.

While following a very strict schedule for mechanical investing is an excellent idea, it would be silly to contend that it matters whether you trade one week or another or whether you trade your quarterly strategy every 13 weeks or 14 weeks. The value of following a strict schedule is that it keeps your portfolio mechanical and helps you avoid falling into emotional traps. It's one thing to put off trading because you're in a car crash on Friday afternoon or because your data isn't fresh; it's quite another to put off trading because your stocks are down and you are hoping that they'll come back up before you sell them.

Finally, I want to reiterate that starting next week, the Foolish Four will be but one mechanical strategy among many in our new Workshop Portfolio. The Foolish Four will be incorporated into the Workshop area and the Workshop will be expanding to three columns per week: Tuesday, Thursday, and Friday. Todd Beaird will still be writing a research-oriented article on Tuesdays, Elan Caspi will be highlighting the best posts from the Foolish Workshop and Mechanical Investing boards on Thursdays, and I will be writing a beginner's level column on Friday.

Workshop portfolio trades will be announced once per month on Fridays, and the trades will take place within the next five business days in accordance with Motley Fool policy. As a practical matter we will aim to make the trades midday on the following Monday.

Tomorrow: A recap of the Foolish Four's history, and a look ahead.

Fool on and prosper!

Read More Foolish Four Reports

Top Dow Stocks
( RP Order )


1. Philip Morris
2. * Eastman Kodak
3. * General Motors
4. * Caterpillar
5. * DuPont
6. Int'l Paper
7. SBC Comm.
8. Alcoa
9. Honeywell
10. Exxon Mobil

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

Foolish Four Portfolio

12/28/00 as of ~8:30:00 PM EST

Ticker Company Price
Daily Price
% Change
EKEASTMAN KODAK1.313.38%40.19
GMGENERAL MOTORS(0.69)(1.34%)50.75
JPMMORGAN (JP)1.380.80%173.00

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Foolish Four0.65%2.45%14.41%(8.54%)12.27%5.91%
S&P 500 (DA)0.40%2.15%1.46%(9.15%)9.18%4.45%
DJIA (DA)0.60%2.16%4.29%(5.39%)19.93%9.44%

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.