Meaning of 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 purchases 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. The ultimate aim of portfolio revision is maximization of returns and minimization of risk.
Constraints in Portfolio Revision:
Portfolio revision is the process of adjusting the existing portfolio in accordance with the changes in financial markets and the investor‘s position so as to ensure maximum return from the portfolio with the minimum of risk. Portfolio revision or adjustment necessitates purchase and sale of securities. The practice of portfolio adjustment involving purchase and sale of securities gives rise to certain problems which act as constraints in portfolio revision. Some of these are as under:
- 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 gain, 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 gains which would be taxed at a higher rate compared to long-term capital gains. The higher tax on short-term capital gains may act as a constraint to frequent portfolio revision.
- 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
Two different strategies may be adopted for portfolio revision, namely an active revision strategy and a passive revision strategy. The choice of the strategy would depend on the investor‘s objectives, skill, resources and time.
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. The practitioners of active revision strategy are confident of developing better estimates of the true risk and return of securities than the rest of the market. They hope to use their better estimates to generate excess returns. Thus, the objective of active revision strategy is to beat the market.
Active portfolio revision is essentially carrying out portfolio analysis and portfolio selection all over again. It is based on an analysis of the fundamental factors affecting the economy, industry and company as also the technical factors like demand and supply. Consequently, the time, skill and resources required for implementing active revision strategy will be much higher. The frequency of trading is likely to be much higher under active revision strategy resulting in higher transaction costs.
Passive revision strategy, in contrast, involves only minor and infrequent adjustment to the portfolio over time. The practitioners of passive revision strategy believe in market efficiency and homogeneity of expectation among investors. They find little incentive for actively trading and revising portfolios periodically.
Under passive revision strategy, adjustment to the portfolio is carried out according to certain predetermined rules and procedures designated as formula plans. These formula plans help the investor to adjust his portfolio according to changes in the securities market.
Formula Plans in Passive Revision Strategy
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. But investors are hesitant to buy when prices are low either expecting that prices will fall further lower or fearing that prices would not move upwards again. Similarly, when prices are high, investors hesitate to sell because they feel that prices may rise further and they may be able to realize larger profits.
Thus, left to themselves, investors would not be acting in the way required to benefit from price fluctuations. Hence, certain mechanical revision techniques or procedures have been developed to enable the investors to benefit from price fluctuations in the market by buying stocks when prices are low and selling them when prices are high. These techniques are referred to as formula plans.
Formula plans represent an attempt to exploit the price fluctuations in the market and make them a source of profit to the investor. They make the decisions on timings of buying and selling securities automatic and eliminate the emotions surrounding the timing decisions. Formula plans consist of predetermined rules regarding when to buy or sell and how much to buy and sell. These predetermined rules call for specified actions when there are changes in the securities market.
The use of formula plans demands that the investor divide his investment funds into two portfolios, one aggressive and the other conservative or defensive. The aggressive portfolio usually consists of equity shares while the defensive portfolio consists of bonds and debentures. The formula plans specify predetermined rules for the transfer of funds from the aggressive portfolio to the defensive portfolio and vice versa. These rules enable the investor to automatically sell shares when their prices are rising and buy shares when their prices are falling.
There are different formula plans for implementing passive portfolio revision; some of them are as under:
1. Constant Rupee Value Plan:
This is one of the most popular or commonly used formula plans. In this plan, the investor constructs two portfolios, one aggressive, consisting of equity shares and the other, defensive, consisting of bonds and debentures. The purpose of this plan is to keep the value of the aggressive portfolio constant, i.e. at the original amount invested in the aggressive portfolio.
As share prices fluctuate, the value of the aggressive portfolio keeps changing. When share prices are increasing, the total value of the aggressive portfolio increases. The investor has to sell some of the shares from his portfolio to bring down the total value of the aggressive portfolio to the level of his original investment in it. The sale proceeds will be invested in the defensive portfolio by buying bonds and debentures.
On the contrary, when share prices are falling, the total value of the aggressive portfolio would also decline. To keep the total value of the aggressive portfolio at its original level, the investor has to buy some shares from the market to be included in his portfolio. For this purpose, a part of the defensive portfolio will be liquidated to raise the money needed to buy additional shares.
Under this plan, the investor is effectively transferring funds from the aggressive portfolio to the defensive portfolio and thereby booking profit when share prices are increasing. Funds are transferred from the defensive portfolio to the aggressive portfolio when share prices are low. Thus, the plan helps the investor to buy shares when their prices are low and sell them when their prices are high.
In order to implement this plan, the investor has to decide the action points, i.e. when he should make the transfer of funds to keep the rupee value of the aggressive portfolio constant. These action points, or revision points, should be predetermined and should be chosen carefully. The revision points have a significant effect on the returns of the investor. For instance, the revision points may be predetermined as 10 per cent, 15 per cent, 20 per cent, etc. above or below the original investment in the aggressive portfolio. If the revision points are too close, the number of transactions would be more and the transaction costs would increase reducing the benefits of revision. If the revision points are set too far apart, it may not be possible to profit from the price fluctuations occurring between these revision points.
Example: Let us consider an investor who has Rs. 1,00,000 for investment. He decides to invest Rs. 50,000 in an aggressive portfolio of equity shares and the remaining Rs. 50,000 in a defensive portfolio of bonds and debentures. He purchases 1250 shares selling at Rs. 40 per share for his aggressive portfolio. The revision points are fixed as 20 per cent above or below the original investment of Rs. 50,000.
After the construction of the portfolios, the share price will fluctuate. If the price of the share increases to Rs. 45, the value of the aggressive portfolio increases to Rs. 56,250 (1250 * Rs. 45). Since the revision points are fixed to 20 per cent above or below the original investment, the investor will act only when the value of the aggressive portfolio increases to Rs. 60,000 or falls to Rs. 40,000. If the price of the share increases to Rs. 48 or above, the value of the aggressive portfolio will exceed Rs. 60,000. Let us suppose that the price of the share increases to Rs. 50, the value of the aggressive portfolio will be Rs. 62,500. The investor will sell shares worth Rs. 12,500 (250 * Rs. 50) and transfer the amount to the defensive portfolio by buying bonds for Rs. 12,500. The value of the aggressive and defensive portfolios would now be Rs. 50,000 and Rs. 62,500 respectively. The aggressive portfolio now has only 1000 shares valued at Rs. 50 per share.
Let us now suppose that the share price falls to Rs. 40 per share. The value of the aggressive portfolio would then be Rs. 40,000 (1000 * Rs. 40) which is 20 per cent less than the original investment. The investor now has to buy shares worth Rs. 10,000 (250* Rs. 40) to bring the value of the aggressive portfolio to its original level of Rs. 50,000. The money required for buying the shares will be raised by selling bonds from the defensive portfolio. The two portfolios now will have values of Rs. 50,000 (aggressive) and Rs. 52,500 (i.e. Rs. 62,500 – Rs. 10,000) (defensive), aggregating to Rs. 1,02,500. It may be recalled that the investor started with Rs. 1,00,000 as investment in two portfolios.
Thus, when the ‘constant rupee value plan’ is being implemented, funds will be transferred from one portfolio to the other, whenever the value of the aggressive portfolio increases or declines to the predetermined levels.
2. Constant Ratio plan
This is a variation of the constant rupee value plan. Here again the investor would construct two portfolios, one aggressive and the other defensive with his investment funds. The ratio between the investments in aggressive portfolio and the defensive portfolio would be predetermined such as 1:1 or 1.5:1 etc. The purpose of this plan is to keep this ratio constant by readjusting the two portfolios when share prices fluctuate from time to time. For this purpose, a revision point will also have to be predetermined.
Suppose the revision points may be fixed as +/- 0.10. This means that when the ratio between the values of the aggressive portfolio and the defensive portfolio moves up by 0.10 points or moves down by 0.10 points, the portfolios would be adjusted by transfer of funds from one to the other.
Let us assume that an investor starts with Rs. 20,000, investing Rs. 10,000 each in the aggressive portfolio and the defensive portfolio. The initial ratio is then 1:1. He has predetermined the revision points as + 0.20. As share price increases the value of the aggressive portfolio would rise. When the value of the aggressive portfolio rises to Rs. 12,000, the ratio becomes 1.2:1 (i.e. Rs. 12,000 : Rs. 10,000). Shares worth Rs. 1,000 will be sold and the amount transferred to the defensive portfolio by buying bonds.
Now, the value of both the portfolios would be Rs. 11,000 and the ratio would become 1:1. Now let us assume that the share prices are falling. The value of the aggressive portfolio would start declining. If, for instance, the value declines to Rs. 8,500, the ratio becomes 0.77:1 (i.e. Rs. 8,500 : Rs, 11,000). The ratio has declined by more than 0.20 points. The investor now has to make the value of both portfolios equal. He has to buy shares worth Rs. 1,250 by selling bonds for an equivalent amount from his defensive portfolio. Now the value of the aggressive portfolio increases by Rs. 1,250 and that of the defensive portfolio decreases by Rs. 1,250. The values of both portfolios become Rs. 9,750 and the ratio becomes 1:1. The adjustment of portfolios is done periodically in this manner.
3. Dollar cost averaging
This is another method of passive portfolio revision. All formula plans assume that stock prices fluctuate up and down in cycles. Dollar cost averaging utilizes this cyclic movement in share prices to construct a portfolio at low cost.
The plan stipulates that the investor invest a constant sum, such as Rs. 5,000, Rs. 10,000, etc. in a specified share or portfolio of shares regularly at periodical intervals, such as a month, two months, a quarter, etc. regardless of the price of the shares at the time of investment. This periodic investment is to be continued over a fairly long period to cover a complete cycle of share price movements.
If the plan is implemented over a complete cycle of stock prices, the investor will obtain his shares at a lower average cost per share than the average price prevailing in the market over the period. This occurs because more shares would be purchased at lower prices than at higher prices.
The dollar cost averaging is really a technique of building up a portfolio over a period of time. The plan does not envisage withdrawal of funds from the portfolio in between. When a large portfolio has been built up over a complete cycle of share price movements, the investor may switch over to one of the other formula plans for its subsequent revision. The dollar cost averaging is specially suited to investors who have periodic sums to invest. All formula plans have their limitations. By their very nature they are inflexible.
Further, these plans do not indicate which securities from the portfolio are to be sold and which securities are to be bought to be included in the portfolio. Only active portfolio revision can provide answers to these questions.