Page 343 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes portfolio. In this example, we have used fractional shares and have ignored transaction
costs to simply the example. In order to highlight the revaluation actions of our investors,
we have shown them ‘boxed’ in Table. The value of the buy-and-hold strategy is shown in
column (2) to enable comparison with the total value of our investors’ portfolio column
(5) as per constant-dollar-value plan of portfolio revision. Notice the revaluation actions
(represented by boxed areas in Table taken when the price fluctuated to 20, 24 and 28.8,
since the value of the aggressive fund became 20% greater or less than the constant value
of 10,000. Notice also that the investor using the constant-dollar-value formula plan has
increased the total value of his fund to 20,700 after the complete cycle, while the buy-
and-hold strategy yielded only 20,700. Let us now illustrate another formula plan,
namely, constant-ratio-plan.
4. Constant-ratio Plan: This is an investment strategy in which the portfolio’s composition
by asset class is maintained at a certain level through periodic adjustments. When the
balance is upset, it is periodically restored by moving money from over-performing
assets to under performing ones.

Notes This system prevents one asset class from dominating the portfolio. This is one way
to maintain a desirable asset allocation.
The constant-ratio plan specifies that the value of the aggressive portfolio to the value of
the conservative portfolio will be held constant at the predetermined ratio. This plan
automatically forces the investor to sell stocks as their prices rise, in order to keep the
ratio of the value of their aggressive portfolio to the value of the conservative portfolio
constant. Likewise, the investor is forced to transfer funds from conservative portfolios to
aggressive portfolios as the price of stocks fall. We may clarify the operations of this plan
with the help of an example.

Example: For the sake of our example, the starting point and other information are the
same as in the previous example. The desired ratio is 1:1. The initial fund of 20,000 is thus
divided into equal portfolios of 10,000 each. The action points are predetermined at + .10 from
the desired ratio of 1.00. The table shows, in boxes, the actions taken by our investor to readjust
the values of the two portfolios to re-obtain the desired ratio.

Example of Constant-Ratio Formula Plan

(1) (2) (3) (4) (5) (6) (7) (8)
Stock Value of Value of Value of Total Value Ratio Revaluation Total
Price Buy-and- Conservative Aggressive of Constant (4): (3) Action No. of
Index Hold Portfolio Portfolio Ratio Shares
Strategy (Col.5-Col.4) (Col.8xCol.1) Portfolio in
(800 shares (Col.3+Col.4) Aggressive
xCol.1) Portfolio
( ) ( ) ( ) ( )
25 20,000 10,000 10,000 20,000 1.00 400
23 18,400 10,000 9,200 19,200 0.92 400
22.5 18,000 10,000 9,000 19,000 0.90 400
22.5 18,000 9,500 9,500 19,000 1.00 Buy 22.2 422.2 Contd...
Shares
at 22.5 *
20.25 16,200 9,500 8,540 18,040 0.90 Buy 23.7 422.2
20.25 16,200 9,020 9,020 18,040 1.00 445.9
338 LOVELY PROFESSIONAL UNIVERSITY Shares

at 20.25
20 16,000 9,020 8,910 17,930 0.99 445.9
22.4 17,920 9,020 9,920 18,940 1.10 445.9
22.4 17,920 9,470 9,470 18,940 1.00 Sell 20.1 445.9
Shares
at 22.4
24.6 19,920 9,470 10,430 19,900 1.10 425.8