Factoring Risk Into Your Investment Formula

by David Jenyns on November 2, 2007

The investor who concludes that he might profit by using a formula is, naturally, faced with the problem of what type he wants to use, and exactly what kind of rules he is going to set up for himself. A basic consideration, of course, is the amount of risk he is willing to assume.

The element of risk is present in all investment schemes, and it is the purpose of a formula to minimize it, while working toward some growth of capital. The amount of risk the investor wants to build into his formula is up to him the more risk the greater the profit possibilities. The constant-ratio plans examined earlier assumed a 50-50 stock-bond relationship, but an investor willing to take on more risk would be perfectly justified in setting the stock percentage substantially higher at 80 percent, say.

Although, as discussed in detail earlier, there is no “best” formula that will suit all investors, the two which are widely used, practical, easy to operate and profitable over periods of time are dollar averaging and the constant-ratio plan. Most investors can undoubtedly profit by using one or another of these, adjusting them to suit individual needs. The two can quite easily be combined to take advantage of the merits of each. If it were possible to predict what type of market is in the cards for next year, it would be easy to construct exactly the right formula but then it would be even easier and more profitable to throw out formulas altogether.

Aside from the question of risk, convenience and psychological satisfaction also must influence the choice of a formula. For example, an investor who finds even the relatively simple mathematics involved in the Graham or Genstein intrinsic-value plans irksome would be foolish to try to follow such a system. And the investor who has little faith in the infallibility of the Keystone channels would undoubtedly not for long follow one of them even if he started. The formula must “feel” right; the investor must be convinced of the value of the formula, so that he will not be tempted to discard it when it happens to be performing poorly.

The formulas described are felt to offer a representative sampling of the most practical or widely publicized types to enable the investor to select whatever features he may prefer. There are numerous possibilities for other plans. A good source of future formula methods might well be in market “timing” techniques such as the “confidence index,” one or another of the breadth indexes or advance-decline indicators, or the strength measurements issued by Lowry’s Reports. These technical approaches to the market could undoubtedly be adapted easily to the formula principle. A formula based on current stock yields would probably have given good results over past years.

It is possible that a good formula could be built around the loan-deposit ratios of commercial banks, the underlying assumption being that the Federal Reserve Board, which influences this ratio by its actions in the money market is a major influence on the stock market. Although the relationship of business cycles to stock market cycles was distant during the war and postwar years, it may be that a formula based on business indicators might again be profitable in the future. All these areas, of course, would require detailed investigation, but the important point is that the reader need not feel restricted to the formulas that have been devised in the past.

A smart investor will take past formulas, see what has worked and what hasn’t, and then build his own using that information. As always, the savvy investor will look at all his options before striking — and with any luck he’ll hit while the iron is hot.

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