The difficulties of building a fortune in the stock market are a painfully familiar subject to the large majority of those who have tried it. The gap between the apparent ease of beating the market and actual results of investors—both professional and amateur— is the principal justification for stocks formula and, hence, for this book.

A pungent argument in favor of stocks formula can be seen in an article in Fortune a few years ago.1 Entitled "Wall Streeters Who Were Right," the essay lauds a number of financial analysts who correctly called the turn prior to the slump that began in the summer of 1957. In a piece ostensibly dedicated to the brilliance of certain forecasters, the author may have had his tongue at least partly in cheek when he blandly observed that, "significantly," the analysts in question differed in "predicting what now lies ahead.

" Significantly? A cynical observer might assume the significance to be that the article was not more accurately entitled "Wall Streeters Who Were Lucky," and that some of them were shortly going to cease being lucky. Obviously, if the forecasters disagreed about the market's immediate prospects, some of them were going to have to be wrong, since the market can go in only one direction at a time.

The purpose of this is not to disparage a group of men making an honest living in a notoriously difficult field, but simply to note the dangers of making dogmatic judgments on the future of stock prices. Probably the safest prediction ever made of the stock market was the succinct prophecy: "It will fluctuate," which, according to Wall Street folklore, was made by J. P. Morgan after a lengthy conference with his most trusted associates. While the story may be apocryphal, the validity of the statement is not. And the idea of formulas was developed to cope with these fluctuations and indeed to rely to some extent on their occurrence for successful investing.

Formulas Work Automatically

A stocks formula is, in essence, a device which, taking its cues from developments outside the individual investor's field of judgment, caprice or personal opinion, dictates a definite investment policy at all times. It does not select stocks, but it does indicate whether a particular time is favorable for owning stocks, and if so, in what quantities, and how much of an investor's capital should be reserved for later stock purchases at more favorable levels. And because the investor himself selects his own formula and builds into it a degree of risk consonant with his investment objectives and willingness to take risks, the instructions of the formula are always in line with the investor's own goals.

A stock formula's primary purpose is to provide a degree of protection against losses caused by unforeseen market swings, and in fact use these swings as an integral part of their operation, by dictating sales of stock (or reduced purchases) as the market nears a top, and increased purchases when it bounces along a low point.

Many investors, when told the market is "too high," might well want to ask: "Too high for what?" The formula tells them —and defines investment action (or lack of it) in terms of their own portfolios and investment objectives. In addition, it has— as we shall see—built-in safeguards against the indecision that tends to afflict almost every investor at some time, the temptation to become over-reckless or over-conservative, and even the imperfections of the formula itself.

The primary objective of a formula is to place the investor in a permanent and continuous profit position. It is gauged to produce profits—over a period of time—whatever happens in the market. When stock prices rise, his portfolio shows a profit. When they fall, he steps up his purchases at bargain levels. At intermediate points, he relies on the indications given by the formula 'to continuously strengthen his profit position. One of the earliest investigators in the field of formula investing drew an analogy with a "thermostatic control" 2 which—like any other thermostatic control—works automatically at all times without asking the investor to use his own judgment.

From this description, it may seem that stocks formula are nothing but an elaborate extension of the time-honored advice to "buy low and sell high." This is, in fact, the case. The special feature of the formula method is that it tells the investor exactly what to do at all times without attempting a precise prediction of market prices. Implicit in the formula idea is that it is not possible to pinpoint every turn in the market or to gain maximum profits during every market swing. Formulas make no attempt to do this, but are aimed at putting the investor in a position to profit to some extent from any market upswing, and to provide some protection during every decline.

Growth Of Formulas

The search for automatic investing techniques—schemes which would produce profits by giving investors advance indication of market swings, based on a mechanical interpretation of market data—has been going on for quite some time. One of the earliest methods was the "Dow Theory," a set of rules for interpreting market action drawn up by William Peter Hamilton about 40 years ago, which were roughly based on the writings of Charles H. Dow. The question of how to apply the various Dow Theory rules is still subject to considerable dispute among adherents of the method, and the battle of reliability is still being bitterly contested by its supporters and detractors.

The search for mechanical market techniques accelerated after the 1929 crash* which had revealed not only the treacheries of emotion but also the frequently appalling inadequacy of even the most reputable investment advisers. The well-known debacle of the closed-end investment companies during the period following the crash—including those managed by some of the best-known names in Wall Street—indicated to many observers the near-impossibility of reliably predicting the course of stock prices. A striking result of this sad situation—and perhaps the quaintest automatic investing technique ever invented—turned up in this field. This was the so-called "fixed trust." The idea was for the trust to include in its portfolio only securities of what were universally regarded as the "best" corporations. Once set up, the portfolio was to be fully protected from the dangers of investment management. It was not to be altered in any way or for any reason . . . except one. If any corporation stopped paying dividends, its stock was to be forthwith sold. Naturally, by the time a company passes its dividend, the price of the stock usually reflects the fact that it has been in hot water for some time, so this neat gimmick did nothing but insure that stocks would be sold at true distress prices, with the inevitable deterioration of the trust's asset values. Fixed trusts are no longer an important part of the American investment scene.

Stock market forecasters did not stop forecasting during this period, but their results were far from outstanding. A famous study by Alfred Cowles, covering the period from 1928 through 1943 and including 6,904 forecasts of the market as a whole made by 11 experts, showed a score, on average, of about two-tenths of one percent better than random guesswork.3

Investors did not stop losing money, either. Results of an exhaustive research project conducted by Paul Francis Wendt covering the period 1933-38 (on balance, an upward period for the market), indicated that only 21.8 percent of a sample of typical customers came out with a profit.4

Beginning in the thirties, large numbers of automatic investing techniques were developed, bringing into existence dozens of charts, tables, trend lines, moving averages, breadth and depth indicators, complicated mathematical computations, economic indexes, banking data curves, adaptations from the recondite areas of physics and chemistry, and plenty of others. By now, it seems that every available set of statistical data has been put to some use as a forecaster of stock market trends, no matter how tenuous the connection. There is at least one investment adviser known to the writer who predicts the mysterious movements of stock averages by following the no less mysterious movements of celestial bodies.

Some of these "timing devices" are intended to work automatically, and others are subject to considerable interpretation. Some are only sporadically successful, others are worthless, and a great many of them tend to be quite complicated. The principal difficulty with such methods is that they make no allowance for errors. As we have seen, one of the characteristics of formulas is that they do not aim for one hundred percent accuracy, and always make allowances for the probable, while hedging against the possible. A formula method can, however, be combined with a timing device, and an example of this approach is given later in this book.

Eventually, the idea of an automatic formula—which would not be designed to predict market swings with any accuracy, but would still dictate a reliable investment policy, prevent large losses and produce a steady profit over any market cycle— became increasingly attractive.

Originators of formula plans, therefore, eschewed "forecasting" as far as possible, and based their policies on the single assumption that the market would continue to fluctuate—in some cases specifying approximate limits, but without trying to predict their timing.

These earliest stocks formula, in the late thirties and early forties, were largely the handiwork of various institutions, primarily college endowment funds. An automatic formula was especially attractive to such investors. The investment committees, often composed of non-professionals and given to policy disputes, were more than anxious to rely on a formula which would allow them to agree on investment principles and also take them off the hook in case the institution's investments didn't fare too well. One of the foremost pioneers in the field of formulas, Robert Warren (formerly director of exploratory research for Keystone Custodian Funds, Inc.) first became interested in the subject when a Keystone mutual fund distributor in Philadelphia called for help in the case of a local hospital's finance committee which couldn't decide on an investment policy for the hospital's endowed funds. Warren drew up a formula, which presumably satisfied the committee, and went on to explore formulas extensively in subsequent years.

Although the original impetus for formulas came from such large institutions, many of them have long since discarded the formula idea. On the other hand, a rising trend of popularity has been seen in the use of formulas by individuals, perhaps as a result of market experience in recent years, which has so often and so regrettably proved the experts wrong. A number of investment counselors, in fact, have adopted the policy of selling their services on the basis of formula investing techniques.5

Do Formulas Work?

The fact that some stocks formula have wound up in the junk heap after they proved inadequate to changed market conditions has led same 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. Why?

The Answer To Losses

The answer undoubtedly lies in two areas—poor advice and erratic, emotional behavior. Poor advice can come from friends, brokers and advisory services who happen to be wrong. Obviously, it is impossible to detect just how poor the advice is until it is too late, and guarding against it is virtually impossible, especially for the neophyte stocks formula investor.

Emotionalism is another matter. Carefully controlled classroom experiments in speculative behavior have shown that, even when relieved of paying commissions on numerous transactions and of the emotional involvement of handling real money, people tend to chalk up heavier losses than gains—very much as they do in actual investing.6 Furthermore, the lack of correlation between speculative success and (1) intelligence or (2) professional investment experience, suggests that some set of as-yet-unknown emotional factor is at work.

Donald I. Rogers, Business and Financial Editor of the New York Herald Tribune, quoted an unnamed broker to the effect that many investors lose money intentionally (on an unconscious level) in order to assuage deep feelings of guilt.7 Whether or not this is so, the fact is that few investors are really successful in the market. They tend to buy a stock on the crest of its rise, hold it while it goes down, and sell in disgust either before it recovers or when it rises barely enough to produce a slim profit.

There is no reliable method of finding out how successful individual investors are today. But if the Wendt study of investor experience in the thirties is any indication, we may assume that many of them have little reason to be satisfied with their results.

For those investors whose results are somewhat less than brilliant, stocks formula can supply an" answer, and probably can be said to "work," by any reasonable standard. They most certainly help to protect the investor against the dangers of emotionalism, and offer a guide to action that can protect him from acting under the perhaps unwise impulse of the moment. Furthermore, they do not freeze him in an inflexible vise that prevents him from exercising his own judgment or irritates him through lack of action, but they do supply a measure of self-discipline. And if the formula is adhered to with some degree of tenacity, the investor's results should be improved to a great extent.

While it is probably an exaggeration to assert that "any plan is better than no plan," even a mediocre plan may produce better results than those attained by the average hit-or-miss investor, alternately subject to panic, agonies of indecision, impulsive action on ill-advised tips and a hundred other damaging influences.

The essential element for success in the use of a formula is consistent and unwavering application of its rules of operation. Once an investor selects a plan, he can expect satisfactory results only if he sticks reasonably close to it, no matter how bleak the short-term outlook may be. As will be seen, the route to an impressive record of profitable performance is littered with brief periods of relatively unfavorable action. But the simplicity of formulas, and their clear-cut indications for action, make them much more practical even under such adverse circumstances than most other investment techniques.

In short, formulas will not endow the investor with brains if he doesn't already have them, but they do reduce the quantity of brains necessary to come out of the market with a profit.

Inasmuch as a number of stocks formula are discussed in this book, it might logically be expected that one could be singled out as the champion profit-producer. Unfortunately, this cannot be the case. It will be obvious to the reader, of course, that some of the formulas discussed are better than others. Among those which are sound, simple, practical and profitable, however, there is no way of predicting in advance which might prove most satisfactory for any particular investor over any particular period of time.

In the first place, where one formula might gain a slight edge over another in a declining market, another might prove out slightly better in a period of rising stock prices. A comparison of two such disparate methods during any one period, therefore, does not prove very much.

Second, formulas vary in their suitability for a particular individual's circumstances. Some are ideally suited to the investor who has little capital to start with, but expects to have a continuing flow of income which he intends to devote to stock purchases. Others can be adapted to such circumstances with difficulty if at all. Only the investor can choose which method suits his needs best.

Third, some formulas require some record-keeping and a fair amount of calculation, while others call for almost none.

Other Factors

The investor who enjoys—or at least doesn't mind—occupying himself with such things would find these formulas well adapted to his talents, while one who does not wish to bother with any more than a minimum of detail would be foolish to begin managing his investments by one of these plans, because he almost certainly would abandon it within a short time. And if a plan is not followed, can it truly be said to be useful? In the same vein, the suggestion is made at several points in this book that the investor who has a sizable sum of money to invest should invest it slowly over a period of years. Understandably, some investors do not care for this approach, in which case this suggestion is of no value.

Too, there is simply the matter of personal taste. One investor might find a certain stocks formula to fit his own ideas of investing perfectly, either for what he feels to be good and logical reasons or simply because it feels best. This writer attempts to give impartially the arguments for and against all the formulas discussed. Where the arguments for or against a particular approach appear overwhelming, this point is made, but it is not the intention to make up the reader's mind for him. After all, there are no universally accepted opinions in investing; if there were, all investors would want to buy and sell the same securities at the same time, and markets would be impossible.

Finally, none of the formulas in this book are meant to be adopted in quite the same way by any two investors. All can be modified and adjusted by the investor himself. All the necessary tools are given to allow you to make whatever alterations you feel are necessary.

From the earliest research in formula investing, authorities on the subject have emphasized that "the idea of a ready-made plan, which investors are supposed to follow exactly, is not the proper approach to the problem." 8 Every investor has different tastes, needs, prejudices and objectives, and therefore should have a formula which is adapted to them. Lucile Tomlinson, who probably knows more about formulas than anyone else, in referring to her experience in helping investors to draw up formulas, states, "As far as I can recall, no two completed plans have been exactly the same in all details." 9

No one who has studied the subject of stocks formula would pretend that any is perfect. The very theory of a formula, in fact, includes the assumption that it will always be somewhat wrong, but that it will also always be somewhat right, and that it will be more right than wrong over a period of time