What are Formula Plans?
Critically evaluate the various formula plans.
By establishing a specific set of rules for investors to follow, formula
By establishing a specific set of rules for investors to follow, formula
investment plans
try to take the emotion out of investing. A formula investment plan is a
systematic
method of portfolio management. Using it, buy and sell decisions are
strictly
dictated
by security price movements and the changes in individual security
weightings that
result
within a portfolio.
Often, formula plans divide
an investor's portfolio into two
portions:
speculative and conservative. The speculative portion contains aggressive,
volatile
securities
with the potential to earn large returns or create
significant losses.
The conservative portion holds less-volatile
securities—such as government bonds—
that
are expected to grow slowly but steadily.
Investors carefully monitor the
speculative portions of their portfolios. As this
component
changes in value, formula investors add to, or reduce, their positions to
maintain
a
pre-determined level of ownership of speculative securities. This level of
ownership is
simply
measured in dollars in aconstant-dollar plan. In contrast to that,
a constant-ratio
plan maintains
a set percentage of the overall portfolio value in speculative securities.
To ease the problem of timing and
minimise the emotions involved in investing,
mechanical
portfolio management techniques have been developed. These mechanical
techniques
are sometimes employed to “beat the market” through timing.
Some
sort of formula is used to alter exposure to the market from time to time, in
the hope
of
thereby taking advantage of market cycles.
However,
formula plans are primarily oriented to loss-minimisation rather than return
maximisation.
The chapter will examine (1) Constant- Rupee-Value, (2) Constant Ratio,
and (3)
Variable-Ratio formula plans, as well as another mechanical investment plan,
Rupee-Cost
Averaging.
Formula
plans are efforts to make the decision on timing automatic. They consist of
predetermined
rules for both buying and selling of the stock.
The
selection of a formula plan and the determination of the appropriate ground
rules cause
the
investor to consider and outline his investment objectives and policies. Once
the plan is
established,
the investor is free from making emotional decisions based upon the current
attitudes
of investors in the stock market.
Formula
plans are not, however, a royal road to riches without any weaknesses. Firstly,
formula
plans offer only modest opportunity for capital gains.
A fully
managed fund will offer a greater potential gains, even though investors might
not
achieve
this goal. Secondly, some formula plans do not free the investor from making
value
judgement
as to the relative strength of the stock market.
Thirdly,
a formula plan by its very nature must be inflexible, thus imposing a necessary
action
by the investor. Investors may choose securities that do not move with the market.
After
all the beta characteristics of securities are not that stable. Lastly, as an
effort to solve
the
timing problem of investing, they make no provisions for what securities should
be
selected
for investment.
3
different types of formula plans (Numerical Example)
Different
Types of Formula Plans are given below:
1.
Constant-Rupee-Value Plan:
The constant rupee value plan specifies
that the rupee value of the stock portion of the
portfolio
will remain constant. Thus, as the value of the stock rises, the investor must
automatically
sell some of the shares in order to keep the value of his aggressive portfolio
constant.
If the
price of the stock falls, the investor must buy additional stock to keep the
value of
aggressive
portfolio constant.
By
specifying that the aggressive portfolio will remain constant in money value,
the plan
also
specifies that remainder of the total fund be invested in the conservative
fund. The
constant-rupee-value
plan’s major advantage is its simplicity. The investor can clearly see
the
amount that he needed to have invested.
However,
the percentage of his total fund that this constant amount will represent in
the
aggressive
portfolio will remain at different levels of his stock’s values, investor must
choose predetermined
action points sometimes called revaluation points, action points are
the
times at which the investor will make the transfers called for to keep the
constant rupee
value
of the stock portfolio.
Of
course, the portfolio’s value cannot be continuously the same, since this would
necessitate
constant attention by the investor, innumerable action points, and excessive
transaction
costs. In fact, the portfolio will have to be allowed to fluctuate to some
extent
before
action taken to readjust its value.
The
action points may be sent according to prespecified periods of time, percentage
changes
in some
economic or market index, or – mostly ideally – percentage changes in the value
of
the
aggressive portfolio.
The
timing of action points can have an important effect on the profits the
investor obtains.
Action
points placed dose together cause excessive costs that reduce profits.
If the
action points are too far apart, however, the investor may completely miss the
opportunity
to profit from fluctuations that take place between them. An example will help
to
clarify the implementation of formula plans. We will use fractional shares and
ignore
transaction
costs to simplify the example.
Numerical
Example:
To
illustrate the constant rupee value plan, suppose an investor has Rs. 10,000 to
invest.
The
investor decides to begin the plan with balanced portions (Rs.5,000 aggressive,
Rs.5,000
defensive) and to rebalance the portfolio whenever the aggressive portion is 20
per
cent
above or below Rs.5,000.
On
hundred shares of a Rs.50 each stock and Rs.5,000 in bonds are purchased. The
first
column
of Table-1 shows stock prices during one cycle of fluctuation below and back up
to
the
original price of Rs.50. The fifth column shows the adjustments called for by
the 20 per
cent
signal criterion.
The
fourth column shows that by the end of the cycle the investor increased the
total fund
from
Rs.10,000 to Rs.10,209 even though starting and finishing prices were the same
and
the
stock never rose above the Rs.50 starting price.
Main
limitation of the constant rupee value plan is that it requires some initial
forecasting.
However,
it does not require forecasting the extent to which upward fluctuations may
reach.
In
fact, a forecast of the extent of downward fluctuations is necessary since the
conservative
portfolio
must be large enough so that funds are always available for transfer to the
stock
portfolio
as its value shrinks. This step requires knowledge of how stock prices might
go.
Then
the required size of the conservative portfolio can be determined if the
investor can
start
his constant rupee fund when the stocks he is acquiring are not priced too far
above the
lowest
values to which they might fluctuate, he can obtain better overall results from
a
constant-
rupee- value plan.
2.
Constant Ratio Plan:
The
constant ratio plan goes one step beyond the constant rupee plan by
establishing a fixed
percentage
relationship between the aggressive and defensive components. Under both
plans
the portfolio is forced to sell stocks as their prices rise and to buy stocks
as their prices
fall.
Under
the constant ratio plan, however, both the aggressive and defensive portions
remain
in
constant percentage of the portfolio’s total value. The problem posed by re-
balancing
may
mean missing intermediate price movements.
The
constant ratio plan holder can adjust portfolio balance either at fixed)
intervals or when
the
portfolio moves away from the desired ratio by a fixed percentage.
Numerical
Example:
The
chosen ratio of stock to bonds is 1:1 meaning that the defensive and aggressive
portions
will
each make 50 per cent of the portfolio.
Therefore,
we divide the initial Rs.10,000 equally into stock and bond portions. When the
stock
portion rises or falls by 10 per cent from the desired ratio, the original
ratio is
restored.
The
sixth column indicates the four adjustments required to restore the 50:50
balances.
Even
though stock price dropped considerably before rising back to the starting level,
this
portfolio
still made a little bit of money.
The
advantage of the constant ratio plan is the automatism with which it forces the
manager
to
adjust counter cyclically his portfolio. This approach does not eliminate the
necessary of
selecting
individual securities, nor does it perform well if the prices of the selected
securities
do not move with the market.
The
major limitation for the constant ratio plan, however, is the use of bonds as a
haven
stocks
and bonds are money and capital market instruments, they tend to respond to the
same
interest rate considerations in the present discounted evaluation framework.
This
means, at times, they may both rise and decline in value at approximately the
same
time.
There is a limited advantage to be gained from shifting out of the rising
stocks into the
bonds
if, in the downturn, both securities prices decline.
If the
decline in bond prices is of the same magnitude as those in stock prices, most,
if not
all, of
the gains from the constant ratio plan are eliminated. If the constant ratio
plan is used,
it must
be coordinated between securities that do not tend to move simultaneously in
the
same
direction and in the same magnitude.
3.
Variable Ratio Plan:
Instead
of maintaining a constant rupee amount in stocks or a constant ratio of stocks
to
bonds,
the variable ratio plan user steadily lowers the aggressive portion of the
total
portfolio
as stock prices rise, and steadily increase the aggressive portion as stock
prices
fall.
By changing the proportions of defensive aggressive
holdings, the investor is in effect
buying stock more aggressively as stock prices fall
and selling stock more aggressively as
stock prices rise,
Numerical
Example:
It
illustrates another variable ratio plan. Starting price is Rs.50 per share. The
portfolio is
divided
into two equal portions as before, with Rs.5,000 in each portion. As the market
price
drops, the value of the stock portion and the percentage of stock in the total
portfolio
decline.
When
the market price reaches Rs.50, a portfolio adjustment is triggered. The
purchase of
57.5
shares raises the stock percentage to 70. As the stock price rises, the value
of the stock
portion
increases until a new portfolio adjustment is triggered. The sale of 51.76
shares
reduced
the percentage of stock in the portfolio back to 50.
In the
example, the portfolio was adjusted for a 20 per cent drop and when the price
returned
to Rs.50. Other adjustment criteria would produce different outcomes. The
highest
under
this plan results from the larger transactions in the portfolio’s stock
portion.
The
portfolio adjustment section of (sixth column) may be compared with the same
columns.
The variable ratio plan subjects the investor to more risk than the constant
ratio
plan
does. But with accurate forecasts the variable ratio plan designed to take
greater
advantage
of price fluctuations than the constant ratio plan does.
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