The Latest News From The Motley Fool: If you feel emotional, take heart

The Motley Fool started as an irreverent investment newsletter and has grown to become one of the most popular personal finance and investment websites. Anyone who follows its philosophy is called a `Foolish investor'.

ast week we looked at the Beat the Footsie (BTF) investment strategy and examined its descent from the Beat the Dow strategy formulated by the US Motley Fool (if you missed this it is on the UK Motley Fool website at www.fool.co.uk).

Both of these theories are based on work by Michael O'Higgins on dividend yield strategies, which identified blue chip companies whose share price was too low relative to the dividend paid.

Investment methods like this are known as mechanical strategies. This means, simply, that once a strategy has been adopted, you buy the shares dictated by it. If you follow such strategies properly, there will be no place for personal preferences. Mechanical strategies take the emotion out of investing - and that is one of their strengths.

How many people have bought shares based on "good vibrations", or some degree of subjective analysis of the company, only to see the price fall later?

Or perhaps you have bought into a good company where the share prices rose quite nicely for a while and then fell back? In that case, have you ever been unable to sleep because of your failure to take the profit when it was there, instead of hanging on only to lose it again ?

If this sounds like you (and most investors, if they are honest, will admit to have been there once or twice), then a mechanical strategy might be a good approach.

The most successful long-term strategy in history has been to find great companies, where earnings grow from year to year, and keep the shares, ignoring all the short-term ups and downs.

If you cannot switch off and wait patiently and unemotionally, mechanical strategies might be the answer. You may make lower returns than are possible using fundamental analysis, but you still stand a good chance of beating the market, and you will be able to sleep comfortably.

So what other mechanical strategies are there? One selection criterion that has been used successfully by a number of investors is Relative Strength (RS).

This may sound like a complicated bit of financial jargon, but it is quite a simple measure. The RS indicates how a share price has performed over a fixed interval, say a year. Companies with the highest one-year RS values are simply those whose shares have risen the most.

RS values are also quoted over three- and six-month periods too, and any combination of these can be used in an RS strategy.

So a mechanical RS strategy is based on buying into companies where the share price has gone up a lot. It relies for its success on the assumption that shares that are rising will continue to rise.

Do you think that sounds counter-intuitive? Most people instinctively feel it makes sense to buy shares that have been falling in price, as they are more likely to recover.

But the RS strategy does seem to work. And if you check it against past share price data, it is possible to test just how well the strategy has worked.

Developing RS strategies has been an expensive business, out of the reach of many private investors, as historical RS figures have been available only through fee-based subscriptions.

But now the Motley Fool's chief statistical guru has calculated RS figures for the FT-SE 100 companies over five years, and has developed two RS strategies that are regularly updated on the web site.

Like the BTF strategy, you buy the top five companies and keep them for a year. After a year, you work out the top five again, sell those that have fallen out, buy the new entrants, and wait another year. And so on.

The first variant on this strategy is known as the "RS 26-week" strategy, because it is based on the five shares with the highest six-month (26- week) RS values.

The second, the "RS-JT" strategy (named after its founder), uses a combination of three, six, nine, and 12-month RS values. Both strategies have been tested retrospectively over the past five years, starting a new portfolio at the beginning of each month and holding it for a year.

Both variants significantly outperformed the FT- SE 100 index over the five years, making average returns of more than 30 per cent a year. The only difference between them was that the returns from the RS-JT appear to be more consistent.

Having a look at the five-year figures for the RS 26-week strategy (with one portfolio having started every month since April 1994), the portfolios have beaten the FT-SE 100 index 82 per cent of the time and their average return has been 30.8 per cent, compared with 16.5 per cent for the FT- SE 100.

To compare the consistency of the returns, we look at a measure now as the "standard deviation". It sounds fancy, but it is simply a measure of how the returns have varied around the average.

The RS 26-week standard deviation has been 20.1 per cent, against the FT-SE 100 figure of 9.2 per cent. That standard deviation is about the same as the BTF strategy, but with better historical returns.

Returns are not guaranteed. In the case of our RS strategies, there are two main provisos. Remember the popular disclaimer "past performance is no guarantee of future performance?" Well, it is true, and the RS strategies have only been backtested for five years.

The second rider is that those five years have been during a rising stock market, the longest bull market that we have seen for some time. So the strategies have not been tested during a bear phase, when the market is falling.

Many people believe that companies with the highest relative strengths during a bull market are most likely to fall during a bear market, and they may well be right. But, if you look at every year this century, the market has risen far more often than it has fallen. So if you are investing for the long term, can stand the possible downturns, and are prepared to accept more volatile returns, then you may wish to consider looking at RS strategies for some of your money.

www.fool.co.uk

MY SMARTEST INVESTMENT

As a kind of "flutter" when I inherited some money a few years ago, I bought some shares in a company called MICE Group when they went public at about that time. To my great astonishment, these shares are now worth nearly 10 times what I paid for them.

JM, Cheshire

The Fool responds: Well done Fool, you have discovered the power of compounding returns. If you hold shares in good companies for a number of years, it can be quite surprising to see how nicely they can appreciate.

Incidentally though, we would not normally recommend a gambling approach to investment; it is important to research your companies and be sure you have picked ones that you are happy to keep for a long period of time.

Send us your smartest or dumbest investment story. If we publish it, you'll get a free copy of our investment guide. E-mail to UKColumn @fool.com or post to Motley Fool, 79 Baker Street, London W1M 1AJ.

ASK THE FOOL

Every week some 30 companies advertise Private Client Investment Services. I am almost 65 and have a cash fund (from downscaling my life style) reasonably into six figures. How do I choose the best manager or are they likely to deliver similar results?

TK, Suffolk

The Fool responds: For the most part, we haven't been too enamoured of active fund managers at the Fool. Ninety per cent of them regularly underperform the market over five-year periods. If you want to put some money into a fund, we would recommend you have a look at low-charging index trackers as a start, as these will give you returns close to the index itself. For ideas of other strategies, why not post this question on the Motley Fool message boards too? The "Beat the Footsie" strategy, described here last week, might also be of interest to you.

If we publish your question, you'll win a Fool baseball cap. E-mail UKColumn@fool.com or post to Motley Fool, 79 Baker Street, London W1M 1AJ.

FOOLISH TRIVIA

The first five correct answers out of the hat win a de luxe Fool baseball cap.

This company has always struggled in competition with others to put bottoms on seats, and last week it decided to reduce the number of seats. What is it?

Answers by e-mail to: UKColumn@ fool.com or post to: Motley Fool, 79 Baker Street, London W1M 1AJ.

Last week's answer: Telewest

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