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Wednesday, September 15, 1999

The following article originally ran as a Foolish Four article on March 22, 1999.

Managing Expectations

By Ann Coleman (TMF AnnC)

Reston, VA (March 22, 1999) -- Managing expectations. It sounds rather Machiavellian, but I can't think of a more important concept in investing. While one can never know what the future holds, it is very important to have a feel for what one should expect.

Our Foolish Four model is a mechanical stock picking strategy that has been backtested over a 38 year period. That gives us some history that should prove useful in developing expectations. Of course, the future is never the same as the past, and the degree to which the strategy will continue to perform in the future as it has in the past is open to debate.

When we look at our database and consider various time periods, we see that the average returns are fairly consistent no matter when you "start" as long as you remain invested in the strategy for 10 years or longer. In fact, the average annual return (CAGR) for any 10-year period from 1971 on never dropped below 20% per year and was most frequently in the 23% to 24% range.

But that's not the whole story -- not by a long shot. When I blithely quote average returns, no matter how many caveats I try to throw in, I worry that too many folks will remember only the 24% per year number and consequently have the wrong expectations.

Every average conceals more than it reveals. For example, the last time I looked, the average height for men in the US was around 5' 9". Those of us who live here are unlikely to be deceived into thinking that that statistic would be very useful in predicting the height of the next man to walk through a door. But there is a tendency, when one is not familiar with a subject, to attach too much importance to an average.

Once I was in Phoenix and was amazed to find myself in the middle of a ferocious rainstorm that was dumping water so fast that the streets were ankle deep in moments. "This is the desert!" I protested to any native or recent immigrant who would listen. Of course it was, and it was getting about 10 percent of its annual rainfall right then. I had the wrong expectation.

What is dangerous about wrong expectations is that they can lead you to draw the wrong conclusions. (Like, hey, let's camp next to this nice little creek.) Here are just some of the conclusions that have shown up in my mailbox over the last couple of years that are based on wrong expectations:

Wrong expectation 1: The return each year will be 24% or at least close to that.

Wrong conclusion #1: A bad year means the strategy isn't working any more.

Wrong expectation #2: Each stock will go up around 24% a year.

Wrong conclusion #2: If a stock goes up 24% it has grown as much as it is going to so I should sell it and switch one of the current Foolish Four picks.

Wrong expectation #3. All the Foolish Four stocks will go up.

Wrong Conclusion #3: Something is wrong with the strategy if it picks a loser.

Fortunately, we have the tools with which to develop the right expectations. One of them is our historical database. Another is available online in our Dow Statistics Center. It is a History of the Foolish Four extracted from our Dow Spreadsheet. The history shows exactly which stocks would have been selected for a Foolish Four portfolio based on stock prices at the close of trading on the last day of the year.