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Author: fingfool Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 19257  
Subject: Foolish Four Explained Date: 4/22/2000 12:49 PM
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Dear TMF Pixy:

Followed your links on the FF, found the screening methodology and even went to the FF message board for some current discussions. Thanks, it has been a most enlightening endeavor.

I was familiar with Michael O'Higgins publications, so following the FF adaptation of his "Beating the Dow" was straight forward for me. His books make good reading.

Has this board engaged in any follow-up discussions of his newest book "Beating the Dow with Bonds", where he explains his trepidation with the overpriced equity market and his new screen that involves timing the market with investments in either (1) 100% Dow Dogs (5 stock BTD),(2) 100% T-Bonds and -Bills, or (3) 100% 30 Year Zeros, depending on the relative values of the LT Corp AAA bond yield, the S&P 500 earnings yield and annual change in the price of gold? Or for that matter, discussed his being out of the stock market since 1993? Or the back testing of this new screen which handily beats the 5 stock BTD screen over the period from 1969 into 1998?

I judge that O'Higgins has some great insights into the market and particularly in regards to how it moves under the effects of mass psychology. I do not have the risk tolerance to follow his exact screens, but his and a few others' writings have influenced my investment decisions. He also warns of the risk involved in an under diversified portfolio (5 stock BTD).

In tracking down the FF background, I saw the risk/reward of the FF discussed in terms of Beta and Sharpe Ratios. It's my take on modern equity pricing theory that the unsystematic risks (factors effecting individual companies like new products, disasters, bankruptcies) can be eliminated/minimized by diversification and that part of the risk is factored into the price of individual stocks. This theory would indicate that a small stock portfolio would be penalized by this effect. There are of course many examples of where this has not been found in practice, just as higher Beta stocks do not always give the higher returns. But in the long run (before we are all dead) I would expect the market to act in this way.

I calculated and graphed Binomial and Hypergeometric distributions for various probabilities of "bad things" occurring for a large population of companies as applied to a portfolio of 4, 20, and 50 companies. These graphs very dramatically show the safety in numbers, i.e. the lowering of the probability of having a high percentage of bad results with increased portfolio size. On the other side, it shows that diversification also lowers the potential of extremely high rewards, which brings me to my final comment: If one does not have risk aversion to small portfolios, they could look at the O'Higgins PPP (portfolio?? of one) that handily beats the 5 stock BTD from 1973 through 1989. Has there been any analysis/discussion at the TMF of the PPP?

Regards,
fingfool
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