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The Origin of the Stock Market Formula

Aug 17, 2007
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 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.

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.

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.

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.

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.

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 formulas, 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.

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.
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