What is the Rule of 20? Investing Explained

In this series, we break through the jargon and explain a popular investment term or theme. Here it is the rule of 20.

What is it?

There is no connection with the game of bridge, where the rule of 20 is a guideline for players opening the bidding.

It is a measure of stock market valuations that is emerging again as inflation moves towards double digits.

According to the rule, a stock, index or sector is reasonably valued if the P/E ratio (see below) and the current inflation add up to 20.

If the sum of the two is less than that, it is undervalued; if it’s more than 20, it’s overpriced.

The p/e ratio, or price-earnings ratio, is used to determine whether a particular stock, stock market, or stock index is expensive or not.

The ratio, which tells you how much you pay for every penny of profit or gain, is calculated by dividing the stock price by the earnings per share.

You calculate earnings per share by dividing net earnings by the number of shares outstanding.

Who invented it?

Nobody knows. But it was popularized by the philanthropist Peter Lynch, a wildly successful American fund manager who managed Fidelity’s Magellan fund between 1977 and 1990.

Strangely enough, however, it is not one of the 25 investment principles he proposed.

These include: ‘Investing is fun and exciting, but dangerous if you don’t work’; ‘If you can’t find companies that you think are attractive, put your money in the bank until you discover one’; and ‘A stock market crash is as routine as a January snowstorm in Colorado. If you’re prepared, it won’t hurt you.

A decline is a great opportunity to pick up the bargains from investors fleeing the storm in panic.’

What does it tell us about the FTSE 100?

According to Bloomberg, the historical P/E ratio of the FTSE 100 is 13.2.

Add to that current inflation — 9.9 percent — and the result of 23.1 — suggesting the index is expensive. But on the same basis, US indices are still far too expensive.

Should I use the rule?

It is unwise to rely entirely on one standard: nothing in life is so simple.

AJ Bell’s Russ Mold says the Rule of 20 cannot be considered a “clinical market timing tool,” but he argues that it serves as a useful reminder of the effect of inflation on stock prices.

Rising inflation has a negative effect, as it is usually accompanied by higher interest rates that increase the cost of borrowing for businesses, lower profits and reduce their willingness to invest for future growth.

In contrast, low inflation was a major driver of share prices in the 1990s.