Distrusting Market Formula Indicators
The fact that some formulas have wound up in the junk heap after they proved inadequate to predict market conditions has led some observers to conclude that the whole idea must have been poor from the start. This is like saying that because the great majority of automobile companies have folded over the years, the automobile must therefore be a failure.
Many of the earlier formulas were, in fact, poorly devised, resting on inflexible, illogical and fallacious assumptions. Even some of these, however, performed their function well for some time. Many of the basic faults that afflicted the earlier methods have been recognized, and present-day techniques are considerably improved. The reasons behind the early fallacies will be explored more fully in other sections of this book, but it should be pointed out that they did have, the virtue of pointing the way toward better use of the formula idea.
In answering the inquiry of whether formulas “work” certainly a fair question on the part of an investor who may want to subject a large part of his funds to a formula’s dictates we must first ask what we mean by saying that any investment technique “works.”
The de Vegh Mutual Fund, Inc., has answered this question for itself by stipulating that the fund’s management fee is to be chopped in half in any year that the fund’s asset-value performance fails to beat the Dow-Jones Industrial Average by two percentage points, which seems a wholly admirable and unequivocal method of defining the intentions of the fund. In this case, management’s methods have “worked,” and it has earned its full fee in most years since the fund was founded in 1950.
Admittedly, designation of the Dow-Jones Industrials is a somewhat arbitrary choice. Why not the Rails, or the Utilities, or the 65-Stock Composite Average? There is no reason why some other average could not be chosen with equal logic. The point is that the fund states its objective in no uncertain terms, which doesn’t necessarily mean that some other way of setting an objective would not be equally valid.
To take a different example, an amateur trader who has suffered sizable losses in aimless speculation might feel that any technique that promises to yield more than the neighborhood savings bank is one that “works.” For many unsuccessful and embittered speculators, in fact, any method that simply preserved their capital intact would represent a gain over their instinctive systems of “playing the market.”
Some studies have shown that, theoretically, profits are by no means difficult to come by in the stock market. A well-known investment principle which first gained wide popularity in Edgar Lawrence Smith’s “Common Stocks as Long-Term Investments” (1924) is based on the premise that satisfactory profits may be obtained simply by buying blue-chip commons and hanging on to them for a period of years.
This technique, frequently known as the “buy and hold” method of investing, has a rather large following. The basic principle behind the theory is that the long-term trend of the U.S. economy is upward, and that common stock prices will in general reflect this upward trend over the long term. A “buy and hold” investor who began operations at any time in the 1949-60 period would have had rather acceptable results even over the relatively short term.
But most active investors either do not accept the “buy and hold” theory, are dissatisfied with the inactivity it forces on them, or would prefer to shoot for profits over a shorter period of time than the “buy and hold” theory permits. And a great many investors lose money.
That’s why it’s important to research each company in which you plan to invest, and if you can devise a formula—or use someone else’s—so be it. But the truth remains that the best, most consistently successful formula in the stock market is “Slow and steady wins the race.”
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