Page 339 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Sharpe (1975) wrote: “A manager who attempts to time the market must be right roughly
three times out of four, in order to out perform the buy-and-hold portfolio. If the manager
is right less often, the relative performance will be inferior because of transaction costs
and the manager will often have funds in cash equivalents when they could be earning the
higher returns available from common stock.”
Institutional investors who continue to be dominant in the Indian stock market do not
seem to resort to active portfolio revision mainly for statutory reasons. Another feature of
their portfolio revision is that they continue to emphasize individual securities rather
than portfolio risk-return changes.

2. Constraints in Portfolio Revision: A look into the portfolio revision practices as discussed
above highlight that there are a number of constraints in portfolio revision, in general
and active portfolio revision, in particular. Let us indicate some common constraints in
portfolio revision as follows:
(a) Transaction cost: As you know, buying and selling of securities involve transaction
costs, including brokers’ fee. Frequent buying and selling for portfolio revision
may push up transaction costs beyond gainful limits.

(b) Taxes: In most countries, capital gains are taxed at concessional rates. But for any
income to qualify as capital gains, it should be earned after the lapse of a certain
period. In many cases, the period is 36 months. Frequently selling portfolio revision
may mean foregoing capital gains tax concessions. Higher the tax differential
(between rates of tax for income and capital gains), the higher the constraints rise.
Even for tax switches, which mean that one stock is sold to establish a tax loss and a
comparable security is purchased to replace it in the investor’s portfolio, one must
wait for a minimum period after selling a stock and before repurchasing it, to be
declare the gain or loss. If the stock is repurchased before the minimum fixed period,
it is considered a wash sale, and no gain or loss can be claimed for tax purposes.
(c) Statutory Stipulation: In many countries like India, statutory stipulations have been
made as to the percentage of investible funds that can be invested by investment
companies/mutual funds in the shares/debentures of a company or industry.
In such a situation, the initiative to revise the portfolio is most likely to get stifled
under the burden of various stipulations. Government-owned investment companies
and mutual funds are quite often called upon to support sagging markets (albeit
counters) or to cool down heated markets, which put limits on the active portfolio
revision by these companies.
(d) No Single Formula: Portfolio revision is not an exact science. Even today, there does
not exist a clear-cut answer to the overall question of whether, when and how to
revise a portfolio. The entire process is fairly cumbersome and time-consuming.
Investment literature does provide some formula plans, which we shall discuss in
the following section, but they have their own assumptions and limitations.

14.3 Formula Plans

1. Formula Investing: Investment technique is based on a predetermined timing or asset
allocation model that eliminates emotional decisions. One type of formula investing,
called dollar cost averaging, involves putting the same amount of money into a stock or
mutual fund at regular intervals, so that more shares will be bought when the price is low
and less when the price is high. Another formula investing method calls for shifting funds
from stocks to bonds or vice versa as the stock market reaches particular price levels.

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