PORTFOLIO REVISION & FORMULA PLAN
PORTFOLIO REVISION
A
portfolio is a mix of securities selected from a vast universe of securities.
Two variables determine
the composition of a portfolio; the first is the
securities included in the portfolio and the second is the proportion of total
funds invested in each security.
Portfolio
revision involves changing the existing mix of securities. This may be effected
either by changing the securities currently included in the portfolio or by
altering the proportion of funds invested in the securities. New securities may
be added to the portfolio or some of the existing securities may be removed
from the portfolio. Portfolio revision thus leads to purchase and sales of
securities. The objective of portfolio revision is the same as the objective of
portfolio selection i.e. maximizing the return for a given level of risk or
minimizing the risk for a given level of return.
Need for portfolio revision:
The
primary factor necessitating portfolio revision is changes in the financial
markets since the creation of the portfolio. The need for portfolio revision
may arise because of some investor related factor also. These factors may be
listed as-
§
Availability of
additional funds for investment
§
Change in risk
tolerance
§
Change in the
investment goal
§
Need to liquidate a
part of the portfolio to provide funds for some alternative use,
The
portfolio needs to be revised to accommodate the changes in the investor’s
position.
Constraints in portfolio revision:
Portfolio
revision is the process of adjusting the existing portfolio in accordance with
the changes in financial market and the investor’s position so as to ensure
maximum return from the portfolio with the minimum of risk.
§ Transaction cost: buying and selling of securities involve transaction costs such
as commission and brokerage. Frequent buying and selling of securities for
portfolio revision may push up transaction costs thereby reducing the gains
from portfolio revision. Hence, the transaction costs involved in portfolio
revision may act as a constraint to timely revision of portfolio.
§ Taxes: tax is payable on the capital gains arising from sale of
securities. Usually, long term capital gains are taxed at a lower rate than
short term capital gains. To qualify as long term capital gains, a security
must be held by an investor for a period of not less than 12 months before
sale. Frequent sales of securities in the course of periodic portfolio revision
or adjustment will result in short term capital gain which taxed at a higher
rate compared to long term capital gains.
§ Statutory stipulations: the largest portfolios in every country are managed by
investment companies and mutual funds. These institutional investors are
normally governed by certain statutory stipulations regarding their investment
activity. These stipulations often act as constraints in timely portfolio
revision.
§ Intrinsic difficulty: portfolio revision is a difficult and time consuming exercise.
The methodology to be followed for portfolio revision is also not clearly established.
Different approaches may be adopted for the purpose. The difficulty of carrying
out portfolio revision itself may act as a constraint to portfolio revision.
Portfolio revision strategies:
1.
Active revision strategy: involves
frequent and sometimes substantial adjustments to the portfolio. Investors who
undertake active revision strategy believe that security markets are not
continuously efficient. They believe that securities can be mispriced at times
giving an opportunity for earning excess returns through trading in them.
Moreover, they believe that different investors have divergent or heterogeneous
expectations regarding the risk and return of securities in the market.
2.
Passive revision strategy: involves
only minor and infrequent adjustment to the portfolio over time. Under passive
revision strategy, adjustment to the portfolio is carried out according to
certain predetermined rules and procedures designated as formula plans.
FORMULA PLANS:
Formula
plans are certain predefined rules and regulations deciding when and how much
assets an individual can purchase or sell for portfolio revision. Securities
can be purchased and sold only when there are changes or fluctuations in the
financial market.
In
the market, the prices of securities fluctuate. Ideally, investors should buy
when prices are low and sell when prices are high. If portfolio revision is
done according to this principle, investors would be able to benefit from the
price fluctuations in the securities market.
In
other words, the formula plan provides the basic rules and regulations for the purchase
and sale of securities. The amount to be spent on the different types of
securities is fixed. The amount may be fixed either in constant and variable
ratio.
Formula
plan, represents an attempt to explicit the price fluctuations in the market
and make them a source of profit to the investor.
Formula
plan consists of predetermined rules regarding when to buy and sell and how
much to buy or sell.
Why formula plan???
§ Formula plan help an investor to make the best possible use of
fluctuations in the financial market. One can purchase shares when the prices
are less and sell off when market prices are higher.
§ With the help of formula plan an investor can divide his funds
into defense portfolio and aggressive and easily transfer from one portfolio to
other.
v Aggressive portfolio: it consists of funds that appreciate quickly and guarantee
maximum returns to the investor.
v Defensive portfolio: it consists of securities that do not fluctuate much and remain
constant over a period of time.
Assumptions of formula plan:
1.
The first assumption is
that certain percentage of the investor’s fund is allocated to fixed income
securities and common stocks.
2.
The second assumption
is that if the market moves higher, the proportion of stocks in the portfolio
may either decline or remain constant.
3.
The third assumption is
that the stocks are bought and sold whenever there is a significant change in
the price.
4.
The fourth assumption
requires that the investor should strictly follow the formula plan once he
chooses it.
5.
The investor should
select good stocks that move along with the market. They should reflect the
risk and returns features of the market.
Advantages of formula plan:
1.
Basic rules and
regulations for the purchase and sale of securities are provided.
2.
The rules and regulations
are rigid and help to overcome human emotion.
3.
The investor can earn
higher profits by adopting the plan.
4.
A course of action is
formulated according to the investor’s objective.
5.
It controls the buying
and selling of securities by the investor.
6.
It is useful for taking
decision on the timing of investments.
Disadvantages:
1.
The formula plan does
not help the selection of the security.
2.
It is strict and not
flexible with the inherent problem of adjustment.
3.
The formula plan should
be applied for long periods, otherwise the transaction cost may be high.
4.
Even if the investors
adopts the formula plan, he needs forecasting. Market forecasting helps him to
identify the best stocks.
1.
Rupee cost averaging:
The simplest and most effective formula plan is rupee cost
averaging. First, stocks with good
fundamentals and long term growth prospects should be selected. Such stocks’
prices tend to be volatile in the market and provide maximum benefit from rupee
cost averaging. Secondly, the investor should make a regular commitment of
buying shares at regular intervals. Once he makes a commitment, he should
purchase the shares regardless of the stock’s price, the company’s short term
performance and the economic factors affecting the stock market.
In this plan, the investor buys varying number of shares at
various points of the stock market cycle. In a way, it can be called time
diversification.
Advantages:
§ Reduces the averages cost per share and improves the possibility
of gain over a long period.
§ Takes away the pressure of timing the stock purchase from
investor.
§ Makes the investors to plan the investment programme thoroughly
on the commitment of funds that has to be done periodically.
§ Applicable to both falling and rising market, although it works
best if the stocks are acquired in a declining market.
Disadvantages:
§ Extra transaction costs are involved with small and frequent
purchase of shares.
§ The plan does not indicate when to sell. It is strictly a
strategy for buying.
§ It does not eliminate the necessity for selecting the individual
stocks that are to be purchased.
§ There is no indication of the appropriate interval between
purchases.
§ The averaging advantage does not yield profit if the stock price
is in a downward trend.
§ The plan seems to work better when stock prices have cyclical
patterns.
2.
Constant rupee plan: this
plan force the investors to sell when the prices rise and purchase as prices
fall. Forecasts are not required to guide buying and selling. The actions
suggested by the formula timing plan automatically help the investor to reap
the benefits of the fluctuations in the stock prices.
The essential feature of the plan is that the portfolio is
divided into two parts, which consists of aggressive and defensive or
conservative portfolios. The portfolio mix facilitates the automatic selling
and buying of bonds and stocks. This plan enables the shift of investment from
bonds to stocks and vice-versa by maintain a constant amount investment in the
stock portion of the portfolio. The constant rupee plan starts with a fixed
amount of money invested in selected stocks and bonds. When the price of the
stocks increases, the investor sells sufficient amount of stocks of return to
the original amount of the investment in stocks. By keeping the value of
aggressive portfolio constant, remainder is invested in the conservative
portfolio.
The investor must choose action point or revaluation points. The
action point is the times at which the investor has to readjust the values of
the stocks in the portfolio.
Advantages:
§ Purchase and sales are determined automatically.
§ Helps in gaining higher profits.
Disadvantage:
§ Investor should have to be very rational while buying and
selling the stocks.
3.
Constant ratio plan:
It attempts to maintain a constant ratio between the aggressive
and conservative portfolios. The ratio is fixed by the investor. The investor’s
attitude towards risk and return plays a major role in fixing the ratio. The
conservative investor may like to have more of bond the aggressive investor,
more of stocks. Once the ratio is fixed, it is maintained as the market moves
up and down. As usual, action points may be fixed by the investor.
Advantages:
§ The automatism with which it forces the manager to counter
adjust his portfolio cyclically.
Limitations:
§ The money is shifted from the stock portion to bond portion.
4.
Variable ratio plan:
According to this plan, at varying levels of marker prices, the
proportions of the stocks and bonds change. Whenever the price of the stock
increases, the stocks are sold and new ratio is adopted by increasing the
proportion of defensive portfolio. To adopt this plan, the investor is required
to estimate a long term trend in the price of the stocks. Forecasting is very
essential to this plan.
Advantages:
§ Automatically the investor tends to correct his portfolio
portions according to the price changes.
§ With accurate forecast the variable ratio plan takes greater
advantage of price fluctuations than the constant ratio plan.
Limitations:
§
The investor has to
construct the appropriate zones and trend for alterations of the proportions.
§
The selection of
security has to be done by the investor by analyzing the merits of the stock.
The plan does not help in the selection of scrips.
§ If the zones are too small frequent changes have to be done and
it would limit portfolio performance.
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