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2 plans to help you buy low and sell high

September 22, 2008

"Buy when there is blood on the street," advised the legendary investor, Baron Rothschild.

But it takes enormous courage to buy when there is widespread gloom and panic around. However, once you decide your right investment mix between wealth-growing but volatile investment avenues, such as shares, and wealth-protecting ones such as bonds or bank deposits, formula plans can help you automatically achieve the golden key to stock market riches--buy low and sell high.

Formula plans are a type of investment strategy that makes use of pre-determined rules for the nature and timing of change in one's portfolio as the market rises or falls. Such rules ignore prevalent market moods of optimism or pessimism and help you automatically reallocate funds from one asset class to another with changing circumstances, thus helping you automatically buy low and sell high.

How Formula Plans work

A typical formula plan primarily consists of two portfolios, namely an aggressive portfolio and a conservative, or defensive, portfolio. The former consists of securities that are more volatile as compared to the latter. Thus, the conservative portfolio often comprises bonds meant to provide stability to the entire portfolio.

Normally, the greater the difference in the volatility of the two portfolios, the higher is the expected return. In order to attain the maximum volatility spread, it is preferable to have bonds of the highest security ratings in the conservative portfolio. In essence, it is the negative correlation between the two portfolios that leads to gain from formula plans.

As stated at the outset, formula plans are based on pre-determined rules for timing the re-allocation of money from one portfolio to the other. This leads to an automatic sale of an asset class when its prices rise, and its purchase when the prices fall. Accordingly, such strategies achieve the maximum gain when the two portfolios are moving in opposite directions.

One of the major concerns of a formula plan is that prices of stocks and bonds don't always move in opposite directions. When the prices of these two distinct asset classes move in the same direction, it spells bad news for the plan.

In order to overcome this problem, some experts suggest that the entire conservative portfolio should comprise only cash and bank savings account, or money market mutual funds all of which have near-zero volatility, thus providing the maximum volatility spread between the portfolios. On the other hand, the aggressive stock portfolio needs to provide the highest possible volatility.

Let us now consider some of the commonly used formula plans.

Constant Rupee Value Plan

In a constant rupee value plan, the rupee value of the aggressive portfolio is held constant. Whenever the value of the aggressive portfolio rises, a part of it is sold to bring it back to its original (target) value, and the funds generated are re-invested in the conservative portfolio. The converse action is called for in case the value of the aggressive portfolio falls.

The primary advantage of this formula plan is its simplicity. The investor clearly knows the total amount he needs to keep invested in the aggressive equity portfolio at all times. The constant rupee value plan requires setting up action points, also referred to as revaluation points.

These are the points at which the investor makes changes in his two portfolios based on any changes in their respective values. These actions points can be in terms of periodicity, change in some economic or market indicators, or even in terms of percentages.

In order to make the plan more effective, it is important to estimate the possibility, and extent, of fluctuations in the aggressive portfolio's value. This is because the value of the conservative portfolio should be sufficient to provide funds for re-allocation in the aggressive portfolio should there be a steep fall in its value.

Example

Suppose an investor wants to invest Rs. 10 lakh using the constant rupee value plan. He decides that the value of the aggressive portfolio should be Rs. 5 lakh and that the remaining Rs. 5 lakh would be invested in a conservative portfolio comprising bonds.

Accordingly, he purchases 25,000 shares of a company currently trading at Rs. 20 for the aggressive portfolio. He wants to rebalance the portfolio each time the value of the aggressive portfolio moves up or down by 20 per cent. Rebalancing will be done in such a way that the amount invested in the aggressive portfolio is equal to Rs. 5 lakh after each rebalancing. Table 1 shows how the mechanism operates for both upward and downward changes that call for rebalancing the portfolio.

Table 1

Stock Price (Rs.)

Value of the Conservative Portfolio (Rs. lakh)

Value of the Aggressive Value Portfolio (Rs. lakh)

Total Value of the Constant Rs. Value Portfolio (Rs. lakh)

Buy/Sell Securities

Total Number of Shares Held (Lakh)

(1)

(3)

(4)

(5)

(6)

(7)

20.00

5.00

5.00

10.00

-

0.2500

22.00

5.00

5.50

10.50

-

0.2500

24.00

5.00

6.00

11.00

-

0.2500

24.00

6.00

5.00

11.00

Sell 0.04167 lakh shares at Rs.24.00

0.2083

23.00

6.00

4.79

10.79

-

0.2083

20.00

6.00

4.17

10.17

-

0.2083

19.20

6.00

3.99

9.99

-

0.2083

19.20

5.00

5.00

10.00

Buy 0.0526 lakh shares at Rs.19.20

0.2609

Constant Ratio Plan

The constant ratio plan resembles the constant rupee value plan to the extent that this plan also involves a conservative and an aggressive (equity) portfolio. The aggressive portfolio, however, is maintained at a fixed ratio with respect to the conservative portfolio, instead of at a fixed value, as is the case in the constant rupee value plan.

Here, too, the investor needs to be involved in the buying and selling of shares in order to maintain the predetermined ratio. One of the advantages of this plan is that there would never be a situation that the money available from the conservative portfolio would be insufficient to rebalance the portfolio, as can be the case in a constant rupee value plan.

This is simply because the target here is to maintain a fixed ratio, for the aggressive portfolio, and not any absolute value. During times of a sustained rise or fall in the value of the aggressive portfolio, the constant ratio plan offers higher profits as compared to the constant rupee value plan. This is because the returns from equity are higher in a bullish market as compared to a bearish market.

Example

Let us use the same data we used in the previous example, with some modifications, to show how the constant ratio plan works (Table 2). The amount invested in the aggressive portfolio and conservative portfolio is equal and hence the ratio is 1.00. If 25 per cent is invested in aggressive portfolio and 75 per cent in conservative portfolio, then the ratio will be 0.33.

We will revise the portfolio when the ratio changes upwards or downwards from the target value of 1.00 by 10 per cent. Thus, our first action point will be when the ratio either becomes 1.10 or 0.90 based on the direction in which the ratio moves.

Table 2

Stock Price (Rs.)

Value of Conservative Portfolio (Rs. lakh)

Value of Aggressive Portfolio (Rs. lakh)

Total Value of the Portfolio (Rs. lakh)

Ratio

Rebalancing Action

Total Number of Shares in the Aggressive Portfolio (Lakh)

(1)

(3)

(4)

(5)

(6)

(7)

(8)

20.00

5.00

5.00

10.00

1.00

-

0.2500

21.00

5.00

5.25

10.25

1.05

-

0.2500

22.00

5.00

5.50

10.50

1.10

-

0.2500

22.00

5.25

5.25

11.00

1.00

Sell 0.0114 lakh shares at Rs.22.00

0.2386

21.00

5.25

5.01

10.26

0.95

-

0.2386

20.00

5.25

4.77

10.02

0.91

-

0.2386

19.80

5.25

4.72

9.97

0.91

-

0.2386

19.80

4.98

4.98

9.97

1.00

Buy 0.0133 lakh shares at Rs.19.80

0.2519

As the above examples reveal, both constant rupee value plan and constant ratio plan can help you automatically fulfil the golden prescription of successful stock market investing, namely buy low and sell high.

(Excerpt from Intelligent Stock Market Investing  by N. J. Yasaswy, published by Vision Books)

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