Page 340 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 14: Portfolio Revision

If stocks rise to a particular point, a certain amount of the stock portfolio is sold and put in Notes
bonds. On the other hand, if stocks fall to a particular low price, money is brought out of
bonds into stocks.
Somewhat similar to the constant-dollar plan is the constant-ratio formula. It is one of the
oldest formulas in existence, having been used as long as 20 years ago. More important, it
still stands up today, and is widely used, despite the drastic changes, which have taken
place in the market.

It fulfils, perhaps, better than any other formula, the basic theoretical requirements of
formula investing. It permits the investor to participate to some extent in bull markets,
while at the same time protecting him from serious price declines. And because it is not
married to a fixed-dollar amount in stocks (as in the constant-dollar plan) or a ‘norm’ (as
in the variable-ratio plans to be discussed in the next unit), the method has a high degree
of flexibility. One reason for its durability and its effectiveness is that no forecast whatsoever
is made about the character of future markets, other than that they will continue to fluctuate,
which is hardly a hazardous assumption.
Because of the clear-cut advantages of this plan, it has been widely used by institutions,
such as trust, endowment and pension funds. Its first use, as will be seen later, was in a
college endowment fund. In past years, however, its popularity with some institutional
investors has waned (although others are still quite satisfied), and it has been adopted
more and more by individuals.

Here is how it works: The total investment fund is divided into two equal portions, one
half to be invested in stocks, the other in bonds. As the market rises, stocks are sold and
bonds are bought to restore the 50-50 relationship. If the market goes down, the reverse
procedure is followed, bonds being sold and stocks bought to return to the 50-50 ratio.
The two plans do share some characteristics, of course, and the object of both is the same.
But the constant-ratio plan does not present the investor with quite so many knotty
decisions during its operation, and results over the long-term have tended to be somewhat
better.
As in the constant-dollar plan, the bond and stock portions of the account may be readjusted
according to changes in the value of stocks held, or in a stock index. As before, the
adjustments can be made as shifts of a certain specified minimum percentage occur, or at
regular intervals. Here again, it is recommended that the investor make the necessary
shifts of bonds and stocks at regular intervals. Studies show that this procedure produces
good results – in addition, of course, to its greater convenience.
As noticed above, the problem of portfolio revision essentially boils down to timing the
buying and selling the securities. Ideally, investors should buy when prices are low, and
then sell these securities when their prices are high. But as stock prices fluctuate, the
natural tendencies of investors often cause them to react in a way opposite to one that
would enable them to benefit from these fluctuations. The investors are hesitant to buy
when prices are low for fear that prices will fall further lower, or far fear that prices won’t
move upward again. When prices are high, investors are hesitant to sell because they feel
that prices may rise further and they may realize larger profits. It requires skill and
discipline to buy when stock prices are low and pessimism abounds and to sell when stock
prices are high and optimism prevails. Mechanical portfolio revision techniques have
been developed to ease the problem of whether and when to revise to achieve the benefits
of buying stocks when prices are low and selling stocks when prices are high. These
techniques are referred to as formula plans. Constant-Dollar-Value Plan, Constant Ratio
Plan and Variable Ratio Plan are three very popular formula plans. Before discussing each

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