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Security Analysis and Portfolio Management
Notes one of these, we may point out basic assumptions and ground rules of formula plans as
follows:
2. Basic Assumptions and Ground Rules of Formula Plan
The formula plans are based on the following assumption.
(a) The stock prices move up and down in cycle.
(b) The stock prices and the high-grade bond prices move in the opposite directions.
(c) The investors cannot or are not inclined to forecast direction of the next fluctuations
in stock prices, which may be due to lack of skill and resources or their belief in
market efficiency or both.
The use of formula plans call for the investor to divide his investment funds into two
portfolios, one aggressive and the other conservative or defensive. The aggressive portfolio
usually consists of stocks while conservative portfolio consists of bonds. The formula
plans specify predesignated rules for the transfer of funds from that aggressive into the
conservative and vice-versa such that it automatically causes the investors to sell stocks
when their prices are rising and buy stocks when their prices are falling. Let us now
discuss, one by one, the three formula plans.
What is Constant Dollar-Value Plan?
Did u know?
Constant Dollar value plan is a investment strategy designed to reduce volatility in which
securities, typically mutual funds, are purchased in fixed dollar amounts at regular intervals,
regardless of what direction the market is moving. Thus, as prices of securities rise, fewer
units are bought, and as prices fall, more units are bought also called constant dollar plan,
also called dollar cost averaging.
3. Dollar Cost Averaging: Periodic investment of a fixed dollar amount, as in a particular
stock or fund or in the market as a whole, on the belief that the average value of the
investment will rise over time and that it is not possible to foresee the intermediate highs
and lows.
Dollar-Cost Averaging – DCA: It is a technique of buying a fixed dollar amount of a particular
investment on a regular schedule, regardless of the share price. More shares are purchased
when prices are low, and fewer shares are bought when prices are high. Also referred to as
“constant dollar plan”.
Investopedia says: “Eventually, the average cost per share of the security will become smaller
and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single
investment at the wrong time. In the UK, it is known as “pound-cost averaging.”
The Constant-Dollar-Value Plan (CDVP) asserts that the dollar value (or rupee value in
Indian context) of the stock portion of the portfolio will remain constant. This in operational
terms, would mean that as the stock rises, the investor must automatically sell some of the
shares to keep the value of his aggressive portfolio constant. If, on the other hand, the
prices of the stocks fall, the investors must buy additional stocks to keep the value of the
aggressive portfolio constant. By specifying that the aggressive portfolio will remain
constant in dollar value, the plan implies that the remainder of the total fund will be
invested in the conservative fund. In order to implement this plan, an important question
to answer is what will be the action points? Or, in other words, when will the investor
make the transfer called for to keep the dollar value of the aggressive portfolio constant?
Will it be made with every change in the prices of the stocks comprising the aggressive
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