What are Formula Plans:
Formula plans are systematic approaches to managing portfolios, aiming to capitalize on price fluctuations that stem from cyclical market movements. These plans are not designed to yield exceptionally elevated profits. Instead, they serve as cautious tactics utilized by investors who prefer to avoid significant risk exposure.
Now that we have established the context, let’s delve into a detailed exploration of four distinct types of formula plans. These plans encapsulate a range of strategies designed to manage portfolios, each with its unique approach:
Dollar-Cost Averaging:
Dollar-cost averaging is a way to invest money regularly in a specific investment, like a company’s shares, at consistent times. It’s like a passive approach where you stick to investing the same amount of money each time. To make this work, you need to invest in a regular schedule. The main goal of dollar-cost averaging is to make the investment grow in value over time. The price of the investment will likely go up and down over time. If the price goes down, you buy more shares each time you invest. If the price goes up, you buy fewer shares each time.
For example, consider a scenario where you invest $500 each month into an ETF. Over the course of a year, you would have contributed a sum of $6,000 to purchase shares in this ETF. Assuming the value of these shares fluctuates, varying from approximately $25 to $30 at the time of your purchases. By the end of the year, it’s possible that the value of your holdings in the fund could have increased to around $7,000, which is over 16% of capital gain compared to a more realistic scenario where, without employing this approach, the capital gain realized would likely fall within the range of 5% to 8%.
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Dollar-cost averaging is a calm strategy where you invest steadily, while other plans might be more active.
Constant-Dollar Plan:
A constant-dollar plan involves splitting a portfolio into two segments: speculative and conservative. The speculative segment includes securities with strong potential for capital gains, while the conservative segment comprises low-risk investments like bonds or a money market account. The targeted dollar value for the speculative segment remains consistent. Trigger points are set, indicating when funds should be withdrawn from or added to this segment based on upward or downward movements. Essentially, the constant-dollar plan captures profits from the speculative part of the portfolio if its value rises by a certain percentage or amount, directing these funds into the conservative part. Conversely, if the speculative portion experiences a decline of a specific percentage or amount, funds are allocated from the conservative segment to bolster it.
Imagine that you’ve established a constant-dollar plan. At the start, your portfolio is valued at $30,000, split equally between a high-beta stock (risky stock with a high return potential) and a low-beta stock (less risky stock compared to the market conditions), each containing $15,000. You’ve chosen to adjust the portfolio’s balance whenever the speculative part deviates by $3,000 from its initial value of $15,000. If the speculative section reaches or surpasses $18,000, you would sell enough shares to bring it back down to $15,000, and the sale proceeds would be added to the conservative part. Conversely, if the speculative portion drops to $12,000 or lower, funds from the conservative section would be used to purchase more shares inside the speculative portion, elevating the value back to $15,000.
Over an extended period of time, if the speculative investment within the constant-dollar plan experiences an increase in value, this growth leads to a corresponding rise in the dollar value of the conservative component within the portfolio. This happens because as profits accumulate in the speculative investment, they are systematically moved into the conservative portion of the portfolio.
Constant-Ratio Plan:
The constant-ratio plan shares similarities with the constant-dollar plan, but it differs by aiming to maintain a specific, unchanging proportion between the speculative and conservative parts of the portfolio. Whenever the actual ratio between these two portions deviates by a predetermined extent from the desired ratio, the plan triggers a rebalancing process. During this phase, transactions are executed to adjust the actual ratio back to the intended ratio. To utilize the constant-ratio plan, decisions must be made regarding the suitable allocation between speculative and conservative investments. Additionally, the point at which the ratio triggers transactions must also be chosen.
For a more comprehensive understanding, let’s consider an example where the initial value of your portfolio is $10,000. You’ve decided to evenly distribute the portfolio, allocating 50% to a high-beta mutual fund with the potential for higher returns, and the remaining 50% to a money market account for stability. Rebalancing is set to occur when the ratio between the speculative part and the conservative part either equals or exceeds 1.25 or drops to 0.75 or below.
In the beginning, both segments of the portfolio have $5,000 each. If the net asset value (NAV) of the mutual fund rises and reaches a ratio of 1.25, you’ll need to sell shares from the speculative portion to restore the balanced 50:50 ratio. On the other hand, if the mutual fund’s NAV decreases, causing the ratio to fall to 0.75 or lower, you’ll need to purchase shares to bring the ratio back up to the desired 50:50 target.
In a constant-ratio plan, the anticipated outcome over the long term is that the speculative securities will experience value appreciation. In response to this, you would engage in selling securities to readjust the portfolio and enhance the value of the conservative segment.
Variable-Ratio Plan:
The variable-ratio plan stands out as the most aggressive among these four relatively passive formula plans. It aims to leverage market movements for the investor’s benefit by engaging in market timing, attempting to seize opportunities to “buy low and sell high.” The ratio between the speculative segment and the overall portfolio value is flexible and changes based on the fluctuations in the value of the speculative securities. When the ratio increases by a predetermined measure, the investment in the speculative portion of the portfolio is decreased. Conversely, if the value of the speculative portion decreases to a significant extent relative to the total portfolio value, the investment in the speculative portion is increased.
To implement the variable-ratio plan, several decisions need to be made. Initially, you must establish the starting distribution between the speculative and conservative segments of the portfolio. Then, you must select trigger points that initiate buying or selling actions. These points are determined by the ratio between the value of the speculative segment and the total portfolio value. Lastly, adjustments in that ratio need to be defined at each trigger point. Let’s consider a scenario where you’re employing the variable-ratio plan. At the outset, you divide your portfolio equally between the speculative and conservative segments. The speculative portion comprises a mutual fund, while the conservative part is represented by a money market account. You decide to adjust the proportions when the speculative portion’s value relative to the total portfolio reaches certain thresholds. as an example, if the speculative portion reaches 70% of the total portfolio value, you will then lower its allocation to 55%. Conversely, should the speculative portion decline to 40% of the total portfolio, you will adjust its allocation upwards to 50%.
The rationale behind this strategy is an attempt to strategically respond to the cyclical fluctuations in the mutual fund’s value. As the fund’s value increases, you capitalize on the gains by reducing your exposure and allocating more to the low-risk money market account. Conversely, when the fund’s value undergoes significant declines, you opt to allocate more capital to the speculative portion, aiming to take advantage of potential future recoveries.
