The 13 Steps to Investing Foolishly
Step 7: Dow Investing Strategies"To recap, building a Foolish Dow Portfolio takes no more than fifteen minutes a year, demands no research materials other than one copy of 'The Wall Street Journal,' is low in commissions, assumes minimal risk, on average triples per year the returns of your average mutual fund, and demands no more than a telephone or modem relationship with a deep-discount broker." -- The Motley Fool Investment Guide
Ok. Step 4 convinced you that index funds are the greatest thing since soap, but can you do better? Do you want to do better? A single-decision investment like an index fund that will outperform 80% to 90% of all mutual funds may be all you want or need from your investments. But better is possible. It takes more work, of course. About 15 minutes a year, once you get the concept.
Consider this: If you can beat the market by just 2% a year, after 25 years your account total would be roughly 50% higher. That's the magic of compounding. Of course, beating the market by 2% a year over 25 years isn't easy. Most mutual fund managers would sell their grandmothers for such a record. And there are no guarantees, but read on for the story of an investment strategy that, over the past 25 years, has beaten the market by a far higher margin. (Past performance is no guarantee of future results -- please stay to the right unless passing.)
We call it the Foolish Four. It is one of several strategies that are part of our Dow Investing approach. Actually, all of the Dow Investing strategies have beaten the market by 3% or more over the past 25 years. We like the Foolish Four the best, though, because it combines incredible returns with relatively low risk.
One caveat: Because it involves selling stocks every year, this is a strategy that will incur capital gains taxes if used in a non-tax advantaged account. Holding an index fund or just buying and holding stocks for many years will provide returns that do not involve paying annual capital gains taxes, so the Foolish Four approach is one that would work better in an IRA than in a normal taxable account.
(For more on why the Fool Four is tailor-made to be used in an IRA, check out our IRA area. The strategy still works in a taxable account, but it loses some of its advantage over long-term, buy-and-hold strategies. If you have both retirement and regular investment accounts, you always want to be sure that you use the retirement account for the strategies that involve the most frequent trading.)
With Dow Investing, you limit your stock selections to
a group of companies that are financially strong, leaders in their field (and, indeed, world leaders), and the bluest of the blue chip stocks. If you select from that group a few companies that, on average, outperform the group, you can enjoy high returns with low risk and beat the market without having to spend hours researching each company's financial statements, competitive situation, and management expertise. So how do you select the few companies that are likely to outperform? We'll get to that. First, let's look at the group.
For the 25 years between 1974 and 1998, the Foolish Four strategy grew at an annualized rate of 24.55%, turning a hypothetical $10,000 into over $2.4 million.
Obviously we are talking about the Dow Jones Industrial Average (DJIA). Many people don't even realize that the famed Dow, star of the nightly news, actually consists of only 30 companies. That's it, just 30 companies that represent American industry. To be chosen as a DJIA company, a company has to be a leader in its industry, financially sound, blah, blah, blah, I think we covered this above. The point is that Dow companies may have rough times (we hope so, otherwise, the strategy wouldn't work), but they have the resources, experience, and brand recognition to weather most storms. They may be down for a while, but they are rarely out.
The secret (well, it's not much of a secret) to the Foolish Four's success, and all Dow Investing strategies' success, is the dividend yield. It's the clue that helps us pick those few stocks that are underpriced relative to the other Dow stocks, yet still financially strong. The dividend yield is simply the annual dividend divided by the current price. It's like the interest rate that a stock pays. (Yield is only part of the return you get from owning a stock, of course. Investors also expect the stock's price to go up and provide them with a nice capital gain. Dividends plus capital gains equals total return.)
A stock may go out of favor for many reasons -- competition, a big lawsuit, global financial instability, lower profits, etc. This causes the price to drop, naturally, as some investors do the usual panic thing and sell because the short-term prospects look bad. While Wall Street pundits wail that the stock is tanking; we say it has gone on sale!
As long as the company continues to pay out its normal dividend, that price drop drives the yield up. (Remember, yield = dividend/price.) And as long as the company can stay on sound financial footing and weather the storm (that's why we limit our universe to the Dow stocks), the higher yield will eventually attract investors, which will lead to a price increase, and voila! -- the stock starts a turnaround that attracts more investors, and pretty soon it's back in everyone's good graces. The trick is to catch it before the recovery -- in other words, while the yield is still high and the price is still low.
Of course, it doesn't always work that way. Some stocks don't recover for years and some get into such trouble that they cut or drop their dividend, and then look out below! That's the nature of investing. Get used to it.
But for the strategy to work, it doesn't have to pick the best stocks, or even avoid all losing stocks, it just has to pick three or four above average stocks most years and do it consistently year in and year out. That's all it does, but it does it well enough that the long-term returns are spectacular.
Selecting those few stocks is obviously the key. You need three things: a list of the current Dow stocks, their dividend yields, and their current prices. You can find these things in most financial publications, various online sites, or you can look right here on the Fool: Today's Stock Lists.
There are three main variations of the Dow Dividend approach. The first, known as the High-Yield 10 or, sometimes,the Dogs of the Dow,is to simply buy the 10
highest yielding stocks (in equal dollar amounts, not equal share amounts) and hold them for one year. After the year is up, update your statistics, sell any of your stocks not still on the top ten list, and replace them with the new highest yielders. Simple enough? From 1974 through 1998, this approach has compounded at an annual rate of 17.95%, beating most professional money managers soundly. In dollar terms, a $10,000 portfolio would have increased to $620,000 over those 25 years. Compare that with the Dow's average compounded return of 15.03% over that same time span, which would have turned that same $10,000 into just over $330,000.
We like this strategy because it combines incredible returns with relatively low risk.
The second variation, which was popularized by Michael O'Higgins in his book, Beating the Dow is called the Beating the Dow 5. In this version, you start with the same 10 stocks used for the High-Yield 10, but you buy only the 5 least expensive of the 10. Buying the cheapest of the 10 stocks has proven over time to improve the approach's returns without adding undue risk. For the last 26 years, the BTD5 approach has compounded at an annual rate of 19.39%, turning a $10,000 investment started in 1974 into over $800,000 at the end of 1998.
Our favorite strategy offers a combination of amazingly high returns and low volatility. It selects just four stocks from the Dow universe, hence the Foolish Four.
The Foolish Four stocks are selected based on the ratio between each stock's yield and price. The actual formula is yield divided by the square root of price. Once you have that ratio for each of the 30 Dow stocks, you rank the stocks by that ratio from highest to lowest. The Foolish Four are stocks 2 through 5 on the list. (The highest-ranked stock is dropped because it tends to have more really baaaad years. Sometimes really high yield and low price can be too much of a good thing.) Buy them, hold them for a year, then trade them in on a new set chosen by the same method.
For the 25 years between 1974 and 1998, this strategy grew at an annualized rate of 24.55%, turning a hypothetical $10,000 into over $2.4 million.
Interested? Read more at these Foolish Four Links:
Current Foolish Four Portfolio Report
- Current Dow Stocks
- Dow Statistics Center
- Detailed Strategy Explanation
- Foolish Four History
- The Foolish Four Book
- Discuss Dow Investing
Want to sink your teeth into something a little more challenging than the practically foolproof Dow approach? Want to really learn about a company that interests you? Read on in Step 8.
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