The investor uses formula plans to facilitate him in making investment decisions for the future by exploiting the fluctuations in prices. The formula plans have sketched the basic rules and regulations for purchasing and selling of investments. The formula plans make the average investors superior to others. These formula plans in portfolio management are based on the fact that the investors will not have the problem of forecasting fluctuation in stock prices and will continue to act according to formula.
So, formula plans are a type of investment strategy that makes use of pre-determined rules for the nature and timing of change in one’s investment portfolio as the market rises or falls.
Rules for Formula Plans
- These plans work according to a methodology which is related for the working of each plan
- These plans cannot be used for short periods of time. The longer the period of holding the investments, the easier for formula plans to work.
- Generally the formula plans are strict, rigid and straight forward out they are not flexible
These plans suggest that there must be two portfolios of an investor, namely aggressive portfolio and conservative portfolio. These plans do not have a selection procedure for the stocks. The methodology adopted by the formula plans is to find out the difference in movements of the aggressive portfolios and the conservative portfolios. The formula plans disclose that when the stocks must be purchased and sold.
Types of Formula Plans in Portfolio Management
An aggressive portfolio will determine the volatile nature of the portfolio and will have large number of fluctuations; whereas the conservative portfolio will be planned to complement the aggressive portfolio and will consist of bonds. The conservative portfolio is a mechanism of defensive operations – The two portfolio when combined together will achieve the results as planned by the formula.
Following are the three important types of formula plans that are found useful in making portfolio investment decisions;
- The Constant Rupee Value
- The Constant Ratio
- The Variable Ratio Formula Plans
1. Constant Rupee Value Plan
This plan indicates the rupee value which remain constant in the stock portfolio of the total portfolio. This formula indicates to the investor that whenever the stock value rises his shares should be sold to maintain a constant portfolio. 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.
This formula plan also indicates to the investor how to place the action points, i.e. the period of time when action should be taken. The action points can be said to be a trade-off between stock and profitability. The investor under the constant rupee value will require the knowledge of how ‘low’ the fluctuations may go but it does not require the forecasting of an upward movement or limit of price rise. So the forecasting by the investor is required even under the constant rupee value formula but the knowledge will be regarding the lower limits or the depression values of the fluctuations.
2. Constant Ratio Plan
Under the constant ratio plan, both the aggressive and defensive portions remain in constant percentage of the portfolio’s total value. This plan method of identifying the ratio of the value in the aggressive portfolio to the value of he conservative portfolio. The aggressive portfolio divided by the market value of the total portfolio should be held constant. 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.
The formula plans based an constant ratio does not require the investor to make forecasts of the lower levels at which the prices fluctuate. Under this plan, the aggressive value is always to be kept by the investor constant of the portfolio’s take a long time to move in a direction which is either upwards/downwards, thus this plan does not work at its optimum value. under this plan, the investor will get high profit if there is a continuous sustained rise or fail in prices. These profits would be higher rather than under the constant rupee value plan or variable ratio plan. The main advantage of the constant ratio plan is the automatism with which it forces the manager to adjust counter cyclically his portfolio.
3. Variable Ratio Plan
Under this plan, the ratios are varied whenever (here is a change in the economic or market index. The significant tool of the variable ratio plan is said to be forecasting. The investor is required to make forecasts in the range of fluctuation which more both above and below the median to find out the different ratios at different levels of stock. The investor lowers the aggressive portion of the total portfolio as stock prices rise and steadily increases the aggressive portion as stock prices fall. Whenever there is a growth trend for common stock, then the variations can be accounted for by exploiting the fluctuations around the long term trends.
To conclude, it is clear from the above discussions, that formula plans are useful for making a decision on the timing of investments. They function according to a methodology which is related for the working of each plan. The utility of the formula plans call for the application of plans in a systematic and methodical manner. These plans enable the investors to assess the total amount that he spend on purchases. The formula plans make the average investor who adopts these techniques superior to other investors, these plans are based on the feet that the investor will not have the problem of forecasting fluctuation in stock prices and will continue to act in the light of the formula given to him. Besides using the formula plans, the investor must consider every stock that he puts in his portfolio with respect to growth potential of the securities.