FOOLISH FOUR PORTFOLIO
The Foolish Four,
and Other Dow Investing Strategies, Explained

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Important Note: This page contains detailed instructions for running a Foolish Four portfolio. Our thinking and our expectations for this strategy (and all Dow-based strategies) have changed. Please note that the returns quoted below are based on calendar-year portfolios for the period 1974-1999. Additional research has shown that investors cannot expect such high returns from these strategies in the future. Please see the Foolish Four Information Center for current information on this style of investing and more reasonable expectations of future returns.

Dow Investing is based on the Dow Jones Industrial Average (DJIA), the most famous index in the world. Indices are used to measure stock market performance, either the overall market or individual industries or various investment types. In the case of the DJIA, you're measuring the performance of the overall stock market by using a group comprising 30 American multinational conglomerates -- companies like General Electric, Disney, Exxon-Mobil, and Intel. In fact, when the TV networks' nightly newsreaders say "the market's up today," they generally are referring to the Dow.

The Dow stocks represent the cream of American big business; not coincidentally, they also represent great places for investors to start investing in individual companies. Most of these companies are so big and so diversified that they are practically mutual funds in themselves. Dow Investing is a time-tested, completely mechanical approach, which will take all the guesswork out of picking individual stocks.

The approach teaches you how to select a group of beaten-down DJIA stocks (we'll explain this below) and buy and hold them for one year, playing the likely turnaround. The work to identify the particular stocks that are most likely to turn around can be executed by any novice, since it involves locating a few figures widely available in any major newspaper. Even better, though, we do the work for you, although we hope you will understand the process thoroughly before you use our numbers and selections.

How to Pick the Stocks
OK, time to explain exactly how to do Dow Investing. The first step is simply to get a list of the 30 Dow Jones Industrial Average stocks. (You can find such a list right here: Current Dow Stocks.) Then you'll need two numbers for each stock -- the current stock price and the annual dividend yield (more about calculating that below). You can find these numbers in the stock tables of any major newspaper or online at Strategy Stocks Live!.

The High Yield Method
There are three main variations of Dow Investing. The first, known as the High Yield 10 or the Dogs of the Dow, is simply to buy equal dollar amounts of the ten Dow stocks with the highest yield and hold them for one year. (In the case of a tie for 10th place, pick the stock with the lower price per share.) After the year is up, find the 10 stocks with the highest yield, sell any of your stocks not still on the top ten list, and replace them with the new highest yielders. Simple enough? This isn't something we came up with, by the way. It's been around for years. It's called the Dogs of the Dow because the high yielding stocks are the ones with prices that are low relative to the dividend paid, indicating stocks that are out of favor. You can think of them as the Investor's Best Friend.

For the last 25 years, this canine approach has compounded at an annual rate of 18.0%, beating the market (15.0%) and most professional money managers soundly. What does that mean in terms of dollars? Well, a $10,000 portfolio would have increased to just over $625,000 over those 25 years while an index fund would have grown to around $330,000 over the same time period.

The High Yield/Low Price Method
The second variation was popularized by Michael O'Higgins in Beating the Dow. This approach starts with the High Yield 10 list described above, but it ranks them by price. The Beating the Dow 5 (sometimes called the Flying Five) are the 5 cheapest stocks on the High Yield 10 list.

The Motley Fool has developed several more efficient variations on this approach, some of which have served time as the official Foolish Four. See The Foolish Four Evolves for a complete history of each.

For the last 25 years, the Beating the Dow strategy has grown at an annualized rate of 19.4%, turning a hypothetical $10,000 into over $840,000 in 25 years.

The Foolish Four -- RP Variation
The third major strategy is our current Foolish Four, originally known as the RP Variation (don't ask!) The Foolish Four also looks for likely turnaround stocks but uses a ratio procedure (oops, gave it away) to combine the effects of low price and high yield.

The actual procedure is to divide the yield by the square root of the price. This gives you a ratio for each stock. Rank the Dow stocks by this ratio highest to lowest. (If you find the math easier, you can square the yield and divide by the price instead. The numbers will be different, but the stocks will be ranked in the same order.) Dump the stock with the highest ratio. Then buy the next four stocks in equal dollar amounts.

Why drop the first stock on the list? Sometimes being #1 is too much of a good thing -- in the past, stocks with both the highest yield and lowest price (lowest price of the 10 high yield stocks, not the entire Dow) have usually turned out to be in serious trouble. You are better off just dropping it in favor of the #5 stock, although technically, as long as the stock with the highest RP ratio isn't both the highest yielder and lowest priced, you could pick it instead of #5.

The underlying rationale for the RP formula is this: High yield is positively correlated with better performance. We already know that the 10 highest yielding Dow stocks outperform the Dow. It's been studied, backtested, forward tested, and analyzed to death and the rationale is obvious -- they are bargains. But the 10 highest yielders don't all do equally well. Some are duds, in fact. The question is, how can you refine that group of 10 down to just the few best performers?

The secret is using the square root of price. Academic studies have found that beta is inversely correlated with price but more strongly with the square root of the price (lower price = higher beta). Beta is a measure of volatility. Volatility just means how rapidly a stock's price moves (up or down).

A stock with a high beta tends to move more rapidly and to greater extremes than the market as a whole. For example, if the market goes up 20%, a stock with a beta of 1.5 would be expected to go up 30% (1.5 times as much). If the market goes down 10%, that 1.5 beta stock would be expected to go down 15%. Of course, beta is based on long-term averages, and no stock follows the rules exactly. Still, stocks with higher betas tend to be more lively, and stocks with betas lower than 1 tend to move more sluggishly.

By selecting stocks with high yields, we are selecting stocks whose price movement is more likely to be up. Therefore, by selecting for high beta, the magnitude of the upward movement is increased. That's the secret of the RP's success.

Bear in mind that all of these strategies pick winners and losers. It's a rare year that every single Foolish Four stock beats the market. But over the long term, the average performance of stocks identified by this formula has been spectacular: 24.5% per year annualized over the last 25 years. Ten thousand dollars invested at the beginning of 1975 would have become almost $2.4 million by the end of 1999.

The Easy Way to Pick Stocks
If all that sounds like too much work, we do it for you and post the results daily right here: Today's Stock Lists. Just remember that it's not Foolish to take someone else's word for which stocks you buy -- please be sure you understand what we are doing here and be capable of doing it yourself before you take our word for it.

Our Demonstration Portfolio
In January 2001, the Foolish Four portfolio was expanded into the Workshop Portfolio where the Foolish Four acts as a value strategy to balance the highly growth-oriented Workshop strategies.

Our demo portfolio started with $4,000 dollars in December of 1998.

Getting Started
OK, you've got your stocks and your high hopes. Then what happens?

Get a broker and buy the stocks: check our Discount Brokerage Center for suggestions. Deciding on a broker can be confusing. Just remember that for the Foolish Four you will be trading a maximum of 8 times per year - so it really doesn't matter if you get the hottest guy out there, with execution times of 2.5 nanoseconds, or someone who sends orders in by pneumatic tube. There are lots of very inexpensive and quite competent online brokers. It's more important to get started than to agonize over your choice.

When to Begin
You can start your Foolish Four or Dow portfolio (any version) at any time of the year, but our research shows rather clearly that portfolios renewed around the beginning or end of the year have done much better over the long run. There is a fairly smooth curve that shows returns peaking in December/January and hitting bottom in the summer months (bottom, in this case, is an average return about equal to the market as a whole.)

You don't have to wait for December to start, though. The higher returns for December and January portfolios are a long term average. Any individual year may or may not follow that pattern. Probably the best thing to do is start whenever you are ready and plan to switch to a December or January cycle the first or second time you renew. Like so:

    If you are in a tax-advantaged retirement account, like an IRA, and your stocks have run up a nice bit by the time December rolls around, you can simply renew your portfolio early the first time which will put you in the sweet spot. Otherwise, you can hold the stocks for another year like you would in a taxable account.

    If your portfolio will be subject to capital gains taxes, you want to be sure to hold your stocks for at least a year and a day. In that case, simply plan to hold your first batch of Foolish Four stocks through the end of the first year until the second December rolls around. (If you are wondering Why December? you can read more about that here: When to Begin?
How will changing the holding time that first year affect your returns? We have no idea, actually. Every year is different. But statistically speaking, a longer holding period doesn't seem to hurt the annualized returns very much at all. Most of these companies, once they get turned around, tend to keep going that way for more than a year. A shorter holding period is actually more dangerous to your final return since most of these stocks take time to get turned around. Holding periods of less than one year tend to give lower annualized returns than holding periods of between one and two years. That's why we say that even IRA accounts may want to hold on for more than a year that first time -- but IRA investors can decide that in December when they see how their first portfolio is doing.

Bear in mind that you probably won't start at the "right" time. The best time to start is usually a few days (weeks, months) after you actually buy your stocks. Or maybe a few days (weeks, months) before. It's better to just do it than to wait around for the "right" time.

Our official Foolish Four portfolio was started on December 24, 1998. Even though the account is an IRA, we will hold each batch of stocks for a year and a day to provide an example anyone can follow.

OK, you've picked your renewal day, now what?

Renewing Yearly
Late December is rollover time. Someday (any day is fine) during the holidays, when you have a few minutes, get out your last brokerage statement or click over to your discount broker's website.

Get your account total, which will be the value of the Foolish Four stocks you are holding plus any dividends that have been paid during the year and any cash you want to add to your portfolio for next year. (Send that in a few days in advance of renewal day.) Divide by 4. OK, that's your target for each stock.

Now, if you want to do this the hard way, get a list of the current Dow stocks from the Today's Stock Lists page or straight from the horse's mouth at the Dow Jones website: Latest Declared Dow Dividends (pick up a pack of dividends while you're there so that you can calculate the yield). Get the current price from any quote server, your local paper, or quote.fool.com. Your first step is to calculate the yield. Take the latest declared dividend, multiply by 4 (to get the annual amount), and divide by the stock's price. That's your yield.

To use the Dogs of the Dow method, simply rank the stocks by yield, highest first, and buy the first five or ten stocks on the list. BTD investors, would do that step first, then rerank the ten yielding stocks by price, lowest to highest, and buy the five lowest priced.

If you are using the Foolish Four method, divide each stock's yield by the square root of its price. Use the resulting ratio to rank the stocks -- highest ratio first. The Foolish Four will be stocks 2-5 on the list.

Now, you have your new list of stocks and the amount to be invested in each one. Whoops! Hey, you already own two of the stocks on the list! That's about right. In a typical year, you will have some repeats. No problem. Historically, stocks that stay on for an additional year (or two) have done well.

To balance your portfolio:
  1. Sell all of the stock that is being replaced. If the stocks that are staying on or above your target value by a significant amount ($500 or so), sell enough shares to bring them down to the general vicinity of the target value, bearing in mind that this will trigger a capital gain if the stock is up in price and if you are not in a tax-advantaged retirement account. (If the market is closed when you place your orders, you're done for now. Wait until your trades have gone through before continuing.)

  2. Once you have confirmation of the actual proceeds from the sales, you can make your purchases. If any of the stocks staying on for a second run are significantly below the target value, buy enough shares to bring them up to the target value (more or less).

  3. Divide the remaining cash in your account (from the sale of stock, dividends received during the year, and cash added) among the new stocks. When you are deciding how many shares to buy, always round down and make sure that rounding down leaves enough cash in your account to cover commissions.

  4. Buy the stocks.

    Important: Don't get carried away with being totally balanced. It makes little sense to buy or sell three shares of a company you are keeping for a second year just to make the numbers look nice. We suggest "balancing" only to the extent that you can do so while keeping the commission cost below 2%. So if you are paying $10 per trade, you wouldn't bother to rebalance anything within $500 of the target value. Unless, of course, you just HAVE to have things balanced.
There is an easier way, though. First, deposit any cash you are adding, then sell the stocks you aren't going to be keeping for second year. Then head on over to our Foolish Buy Calculator which will walk you through the rest of the steps and calculate exactly how many shares you need to buy of each stock.

And so on and so on
Keep in mind that this is a long term strategy -- in the past it has had good years and bad years, but the long-term average has been outstanding.

So if you're convinced that the stock market is the best investment vehicle around, (See the 13 Steps to Investing Foolishly if there is any doubt in your mind), and you want to take the next step in portfolio management beyond a simple index fund, Dow Investing may be for you. With a Spartan commitment of just minutes a year for research (entailing not much more than clicking into our Today's Stock List page once a year, figuring out the amount you need to put in each stock, and placing your trades), you can use a strategy that has thrashed the Wall Street professionals for decades. How very Foolish!