Formula investing refers to investing according to a stated methodology. It is an alternative to simply investing by instinct or investing in companies that interest you. Some believe formula investing is a wise way to invest money or funds because it removes the emotional aspects of investing that can lead some to make bad monetary decisions.
Normally, the term formula investing is applied to allocating money in the stock market or to allocating money between different investments such as stocks, bonds and mutual funds. For example, a formula can be used to dictate how much of a person's money he should have in stocks versus bonds. One common formula involves the investor subtracting his current age from the number 100 to determine what percent of his money should be in stocks. Thus, a person who was 30 years old would have 70 percent of his money in stocks (100 minus 30 equals 70).
Formulas can also be used to determine how and when to buy shares of stock. Shares of stock fluctuate with the market as the perceived value of ownership in a given company goes up and down based on the company's performance and based on economic indicators as a whole. If it is widely believed a company will be increasing its profits, the company may rise in value, while if it is believed a company is likely to do poorly in the future or the economy as a whole is likely to falter, then the stock may decline in value.
There are many different formulas used by formula investors with regards to when to buy stocks. Many of these formulas rely heavily on looking at charts that track the price of a stock over time. For example, moving averages — the amount a stock moves — are determined and patterns are detected in the movement of the stock. One very simple form of formula investing, on the other hand, involves dollar cost averaging, or buying a stock at various times at different prices to receive a lower average price.
The main benefit of formula investing is it removes the reactionary and emotion-driven behavior that can cause an investor to lose money. For example, many investors panic when a stock tumbles and pull their money out to avoid further losses. This can result in selling low when the drop in price is only a temporary setback, causing the investor to lose the money he would have made had he waited for the stock to rise in value.