Rules of thumb have existed in investing ever since people looked for patterns in stock price movements. Market timing was the goal, of course, along with a shortcut to quicker wealth. And it didn’t take much to find one. A limited experience, maybe a modicum of study, could unearth a market timing rule.
The first half of the 1900s had its rules of thumb that worked for a while. Charles Amos Dice wrote about the more popular rules in the decades leading up to 1929:
In the first place, there was the conviction that whatever goes up must sooner or later come down. This seeming truism carried tucked safely away the implication that the distance of the fall would approximate the number of points gained in the preceding rise. Furthermore, it implied that the major advances and declines followed one another in more or less regular recurrence…
In the second place, it was a common prewar and also post war belief that the market might reasonably be expected to be at the end of a major advance after 20 to 24 months of consistent climbing. Even as late as 1923, the old yardstick did not fail the trader… Furthermore, major declines might well be expected to run their course in about 11 to 15 months. Before the trajedy of 1920, there was but one exception to this almost mechanical rule since 1903…
In the third place, it was a common belief, generally acted upon, that the stocks of a sound, well-managed, growing corporation with a good outlook might sell up to ten times its net income or reasonably assured net earnings available for dividends on the common stock per share. If the price should ever go much over ten times the amount available per share, then the price was looked upon as getting outside reasonable bounds…
A fourth standard means of judging the turns of the market was the number of points advance made since the preceding low point. With the exception of the advance of 1911 and 1912, which gained only 22 points, every major period of activity went ahead 45 to 55 points in the industrial averages… The bear phases of the market brought declines that varied from 42 to 50 points on the averages.
Those rules seem silly by today’s standards, but the granddaddy of them all was this:
There was also the old and tried doctrine that when the dividend yield on prices of representative stocks falls somewhat below the yield of competing bonds, the stock prices are about at their high point and a major reaction may soon be expected. When the prices of the junior securities rise to the point where the yield is lower than the yield on senior securities, investors will switch out of the stocks to the senior or better paying and more secure bonds. This was the reasonable thing to do.
The old traders clung to the rules because their experience confirmed they worked. They made money on it, so why change?
What the old traders failed to consider was that rules of thumb are a byproduct of the collective actions of market participants.
When enough people, running enough money, get scared out of stocks because dividend yields fall below bond yields, and do it repeatedly, a pattern emerges. Rules are based on that limited experience. As more people follow the rule it becomes self-fulfilling.
And it works, sometimes for decades. The sell when dividend yields fall below bond yields rule worked like clockwork. Then in 1958 something changed.
New investors and traders came along not bound by the old rules. Their rules were based on a different experience, so they did something else. The pattern broke. The old rule stopped working.
Yet, the old traders, with their old rules, sold out like usual, only to miss out in the end. It was an anomaly they said. The market would correct itself shortly. It never did.
Broken rules of thumb are a lesson in market dynamics. Markets shift. Past patterns break. New patterns emerge. New rules replace old rules, that get replaced themselves.
Human nature finds shortcuts in the most limited experiences only to learn that dynamic markets break rigid rules. The lesson is nothing is fixed. Anything can happen.
A certain amount of humility and open-mindedness is required to not let your experience, and the rules you may follow, bias your actions to the detriment of your portfolio.
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