Formula Plans

Presented by: Ritu Yadav Suryadipta Dutta

Topics to be covered

Introduction

Limitations

Variable Ratio Plan

Constant Ratio Plan

Advantages

Constant rupee value plan

Types

Need

Ritu Surya

Meaning of 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.

Why Formula plans ?

• Formula plans help an investor to make the best possible use of fluctuation in the financial market. One can purchase shares when prices are less and sell off when market prices are higher.

• With the help of formula plans an investor can divide his funds into aggressive and defensive portfolio and easily transfer funds from one portfolio to other.

Aggressive Portfolio

• Aggressive Portfolio consists of funds that appreciate quickly and guarantee maximum returns to the investors.

• Defensive portfolio consists of securities that do not fluctuate much and remain constant over a period of time.

Defensive portfolio

Advantages of the Formula Plans

• Basic rules and regulations for the purchase and sale of securities are provided.

• The investors can earn higher profits by adopting the plans.

• It helps to control the buying and selling of securities by the investors.

• It is useful for taking decisions on the timing of investment.

Types of formula Plans

• The Constant Rupee Value Plan• The Constant Ratio Plan• The Variable Ratio Plan

Constant rupee value plan

• This plan forces the investor to sell when the prices rises and purchases as the price falls.

• In this plan, the rupee value of the aggressive portfolio is held constant. Whenever the value of the aggressive portfolio rises, a part of it is sold to bring it back to its original value, and the funds generated are re-invested in the defensive portfolio.

ExamplePeriod Market

priceNo. of shares

Value of aggressiv

e portfolio

Value of defensive portfolio

Total

1 50 200 10000 10000 200002 44 200 8800 10000 188003 40 200 8000 10000 180004 40 250 10000 8000 180005 44 250 11000 8000 190006 50 250 12500 8000 205007 50 200 10000 10500 20500

Revision Point : 20%

Questions?

Formula Plan

CONSTANT RATIO PLAN An investment strategy in which the market value of stocks and

bonds are kept at a predetermined ratio. That is, when compiling a portfolio, an investor may decide that 60% of its value will consist of bonds and 40% will be stocks. When prices rise or fall on the securities in the portfolio, the investor will buy and sell accordingly in order to maintain the ratio.

A constant ratio plan is a form which is done in order to reduce the risk in the portfolio.

Constant Ratio Plan Constant ratio between the aggressive

and conservative portfolios is maintained.

The ratio is fixed by the investor. The investor’s attitude towards risk and

return plays a major role in fixing the ratio.

Initial Portfolio Value = Rs.20,000 Speculative Portion = 40% Conservative Portion = 60% Desired Speculative to Conservative Ratio =

0.67 Trigger Points: Maximum ratio = 1.33 or above,

Minimum ratio = 0.33 or below

(1) (2) (3) (4) (5) (6) (7) (8)Stock Price Index

Value of Buy and Hold Strategy

(2000 x Col. 1)(₨.)

Value of Speculative

Portfolio(Col. 8 x Col. 1)(₨.)

Value of Conservative

Portfolio(Col. 5 - Col.

3)(₨.)

Total Value of constant

ratio portfolio(Col. 3 + Col. 4)(₨.)

Speculative to

Conservative Ratio(Col. 3 / Col. 4)

Revaluation Action

Transactions

No. of Shares in

Speculative Portfolio

10 20,000 8000 12000 20000 0.67 800

20 40,000 16000 12000 28000 1.33 800

20 40,000 11233.54 16766.46 28000 0.67 Sell 238.32 securities at 20

561.68

7 14,000 3931.76 16766.46 20698.22 0.23 561.68

7 14,000 8304.07 12394.15 20698.22 0.67 Buy 624.61 securities at 7

1186.29

Notes Let the amount be Rs.xWe need to satisfy the following and solve for x:(16000-x)/(12000+x) = 0.67Therefore, x = Rs.4766.46New Amount in the Speculation Portion = 16000 – 4766.46 = Rs.11233.54New Amount in the Conservative portion = 12000 + 4766.46 = Rs.16766.46Securities sold from Speculative Portion = 4766.46/20 = 238.32New Securities in the Speculative Portion = 561.68 Let the amount be Rs.yWe need to satisfy the following and solve for :(3931.76+y)/(16766.46-y) = 0.67Therefore, y = Rs.4372.316New Amount in the Speculation Portion = 3931.76 + 4372.31 = Rs.8304.07New Amount in the Conservative portion = 16766.46 – 4372.31 = Rs.12394.15Securities purchase = 4372.31/7 = 624.61New Securities in the Speculative Portion = 1186.29

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.

Variable Ratio Plan At varying levels of market price, 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 or conservative portfolio.

To adopt this plan, the investor is required to estimate a long term trend in the price of the stocks.

Initial Portfolio Value = Rs.20,000 Initial Speculative to Total ratio = 0.4 {Ratio 2:3} Trigger Points: If the actual ratio goes to 0.6

and above, bring the speculative portion to 0.5 {1:1} and if the actual ratio goes to 0.2 or below, raise the Speculative portion to 0.3

(1) (2) (3) (4) (5) (6) (7) (8)Stock Price Index

Value of Buy and Hold Strategy

(2000 x Col. 1)(₨.)

Value of Speculative

Portfolio(Col. 8 x Col. 1)(₨.)

Value of Conservative

Portfolio(Col. 5 - Col.

3)(₨.)

Total Value of portfolio

(Col. 3 + Col. 4)(₨.)

Speculative to Total Ratio

(Col. 3 / Col. 5)

Revaluation Action

(Transactions)

No. of Shares in

Speculative Portfolio

10 20000 8000 12000 20000 0.4 800

25 50000 20000 12000 32000 0.625 800

25 50000 16000 16000 32000 0.5 Sell 160 Shares at 25

640

15 30000 9600 16000 25600 0.375 640

5 10000 3200 16000 19200 0.17 640

5 10000 5760 13440 19200 0.3 Buy 512 Shares at 5

1152

Notes

Desire Speculative Portion = 0.5 of total = Rs.16000New Amount in the Speculation Portion = 20000 – 4000 = Rs.16000New Amount in the Conservative portion = 12000 + 4000 = Rs.16000Securities sold from Speculative Portion = 4000/25 = 160New Securities in the Speculative Portion = 640

Desire Speculative Portion = 0.3 of total = Rs.5760New Amount in the Speculation Portion = 3200 + 2560 = Rs.5760New Amount in the Conservative portion = 16000 – 2560 = Rs.13440Securities purchase = 2560/5 = 512New Securities in the Speculative Portion = 1152

The Formula Plans The formula plans provide the basic

rules and regulations for the purchase and sale of securities.

The aggressive portfolio consists more of common stocks which yield high return with high risk.

The conservative/defensive portfolio consists of more bonds that have fixed rate of returns.

Summary

Disadvantages of theFormula Plan The formula plan does not help the

selection of the security. Should be applied for long periods,

otherwise the transaction cost may be high.

Investor needs forecasting.

Questions?