Saturday, 3 March 2012

Various methods of taking advantage of the stock market’s cycles: "Formula Investment Plans"

Formula Plans

In the early years of the stock-market rise that began in 1949–50 considerable interest was attracted to various methods of taking advantage of the stock market’s cycles. These have been known as “formula investment plans.” 
  • The essence of all such plans—except the simple case of dollar averaging—is that the investor automatically does  some selling of common stocks when the market advances substantially. 
  • In many of them a very large rise in the market level would result in the sale of all common-stock holdings; others provided for retention of a minor proportion of equities under all circumstances.
This approach had the double appeal of sounding logical (and conservative) and of showing excellent results when applied retrospectively to the stock market over many years in the past. Unfortunately, its vogue grew greatest at the very time when it was destined to work least well.
  • Many of the “formula planners” found themselves entirely or nearly out of the stock market at some level in the middle 1950s. 
  • True, they had realized excellent profits, but in a broad sense the market “ran away” from them thereafter, an their formulas gave them little opportunity to buy back a commonstock position.*
There is a similarity between the experience of those adopting the formula-investing approach in the early 1950s and those who embraced the purely mechanical version of the Dow theory some 20 years earlier.
  • In both cases the advent of popularity marked almost the exact moment when the system ceased to work well. 
  • We have had a like discomfiting experience with our own “central value method” of determining indicated buying and selling levels of the Dow Jones Industrial Average. 
  • The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.† 
  • Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.”

* Many of these “formula planners” would have sold all their stocks at the  end of 1954, after the U.S. stock market rose 52.6%, the second-highest  yearly return then on record. Over the next five years, these market-timers would likely have stood on the sidelines as stocks doubled.

† Easy ways to make money in the stock market fade for two reasons: 
  • the 
    natural tendency of trends to reverse over time, or “regress to the mean,” and,
  • the rapid adoption of the stock-picking scheme by large numbers of people, who pile in and spoil all the fun of those who got there first. 
(Note that, in referring to his “discomfiting experience,” Graham is—as always— honest in admitting his own failures.) 

Ref:  Chap 8 Intelligent Investor by Benjamin Graham

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