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Portfolio Revision Techniques

47816386 Portfolio Revision Techniques

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Page 1: 47816386 Portfolio Revision Techniques

Portfolio Revision Techniques

Page 2: 47816386 Portfolio Revision Techniques

Portfolio Revision• Portfolio Revision is the process of selling certain

issues in a portfolio and purchasing new ones to replace them.

• Periodic reallocation and rebalancing are necessary.

• Reasons to revise portfolio:– Major life event.– Proportion of one asset class increases or decreases

substantially.– Expect to reach specific goal.

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Features of Portfolio• If you own more than one security, you have an

investment portfolio.• Build the portfolio by buying additional stocks, bonds,

mutual funds, or other investments. According to modern portfolio theory, we can reduce investment risk by creating a diversified portfolio that includes enough different types, or classes, of securities so that at least some of them may produce strong returns in any economic climate.

• Main goal of making a portfolio is to increase the portfolio's value by selecting investments that you believe will go up in price.

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• The portfolio which is once selected has to be continuously review over a period of time and then revised depending on the objectives of the investor.

• The important factor to be taken into consideration are the timing for revision. The timing for revision is found out by the use of formula plans. Each of these has its own methodology and is useful for investors to make the profit.

• Constant rupee value • Constant ratio value • Variable ratio formula plan

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Portfolio Revision Techniques

• An investor purchase stock according to his objective and return risk framework. The prices of stock he purchase may fluctuate due to economic activities in country and other changed circumstances in the market. If an investor is able to forecast these changes by developing the framework for the future through careful analysis of behavior and movement of stock prices he is in position to make higher profits. The investor uses formula plans to help him in making decision for the future by exploiting the fluctuation in prices. These 3 formulas are

1. Constant rupee value

2. Constant ratio value

3. Variable ratio formula plans

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• A person using these techniques will make superior profits to other investors because he will be acting under control of the method which he adopts in so much as when others are buying stock he will probably be selling it depending on the formula plan that he is using.

• These formula plans do not help in selection of securities as selection can be done by some other techniques.

• So the formula plans is the technique that helps in the timing of security purchase for the construction of a portfolio, so investor does not make a loss.

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Formula plan

• Formula plans give the basic rules and regulations for purchasing and selling of investments.

• It helps the investor to assess the total amount that he should spend on purchases.

• These plans are action oriented and eliminate the feelings of a person who wishes to make investments. A normal average investor is emotional and would not be able to act rationally in this manner.

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Rules for Formula Plan• It is useful in making decision on the timing of

investment. They do not help in the selection of securities.

• These plans are strict, rigid and straightforward but they are not flexible.

• They are not useful for short period of time they require long period to see the results.

• They do not eliminate the need for making forecast.

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Formulation of the plans • There should be the pool of funds with the

investor. If there are no funds the formula plans are useless.

• In this investment fund of an investor should be divide through the technique of formula plans to achieve the highest possible return and to meet the investor expectations.

• They are able to work when the investor has two portfolios.

1. Aggressive portfolio2. Conservative portfolio

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1. An aggressive portfolio: It will have larger number of fluctuations and will rise very rapidly and also fall very quickly. This portfolio help investor to have high profits and capital gains but at the same time will be very risky.

2. The conservative portfolio: It will consist of bonds. They give stability to the investor portfolio. They also provide stable income. This portfolio will move slowly upwards when the prices are rising and will fall very slowly when the prices are falling.

• The methodology adopted by formula plans is to find difference in the movements of the aggressive as well as conservative portfolios and help to assess the future course of action.

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• The larger and greater the difference between the movements of the two portfolios, the higher the profit that is derived from the formula plan.

• Bonds are useful for current income. Their prices fall in boom period and price of stock rises. This situation is opposite during depression.

• The methodology adopted by the formula plan is to transfer the securities from the conservative portfolio to the aggressive portfolio when the value of aggressive portfolios fall (buy stocks when prices are low).

• The investor should also transfer his securities from aggressive portfolio to the conservative portfolio when the value of aggressive portfolio rises in the market (sell stocks when the prices are rising)

• So this plan also show when the stocks should be purchased and sold.

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• Formula indicates that greater profits are determined when it is noticed that the stock prices and bond prices move in the opposite direction. For instance, if the price of stock rises, the price of bonds should fall. Similarly, when the stock prices are falling, bond prices should rise to give maximum benefits.

• The movements of stocks determine the profits of investor. When the stock prices continue to move and there are greater fluctuations then investor will make large profits.

• The investor should note that the fluctuations in prices will not always move in opposite direction between bonds and stocks. This is desired situation but not realistic situation. Very often in the market both bonds and stocks move in the same direction.

• In this turning points show the direction which the investor should take regarding the purchase to sale of stocks. These turning points sometime coincide and some time not.

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• When the turning points do not coincide it means that bonds and stocks are moving together in the same direction.

• If the investor chooses to have a good current income which is stable, he should consider the choice of a more conservative portfolio which is less volatile in nature.

• The investor should be aware that if he wants to make a higher profits, he is faced by greater risk and higher volatility.

• The quality of investments will depend upon the kind of company and its reputation in the capital market.

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Constant rupee plan

It has the following advantages:

• It is simplest formula plan and has no complicated calculations.

• It has advantage of specifying the percentage of the aggressive portfolio in the investment fund. This amount will be different at different or varying levels of stock value, but it will be continuously constant to the total fund.

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Methodology used by Constant Rupee Value plan

• It indicates the rupee value which remain constant in the stock portfolio. The aggressive portfolio remain constant in the total portfolio.

• This formula indicates to the investor whenever stock value rises his shares should be sold and buy the shares when the prices fall, to maintain a constant portfolio.

• Although the aggressive portfolio has to remain constant to the total portfolio, according to this plan a portion of the total funds should be invested in the conservative fund.

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• In this investor is guided by ‘action points’ which are also known as revaluation points. These action points help the investor to make their transfers from aggressive to conservative portfolio and vice versa in order to maintain the constant rupee value.

• This formula also indicates the period of time when action should be taken. If action points are close together then there will be no profit as the transfer will be expensive and the transaction cost will be high. The action points should not be too far because they loose their value and no profits will be indicated if they are too far. The action points are related to economic activity of aggressive portfolio.

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• A certain range of fluctuations is specified. If the fluctuations of stocks are within this range, no change will be made by the investor from the from aggressive to the conservative portfolio. For example, if 20% is the range specified the investor will make no changes from conservative portfolio to aggressive portfolio within this range. But when fluctuations move beyond this range, the investor will have to plan a change or transfer.

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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%. 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.

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Stock Price

( Rs.)

Value of Conservative Portfolio (Rs. Lakh)

Value of Aggressive Portfolio (Rs. Lakh)

Total value of portfolio

(Rs. Lakh)

Buy & Sell securities.

Total no. of shares held

(lakh)

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 lk shares at Rs. 24

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 lk shares at Rs. 19.20

0.2609

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Constant Ratio plan

• This plan is a method of identifying the ratio of the value in the aggressive portfolio to the value of the conservative portfolio.

• 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.

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• 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

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• An strategy in which the market value of stocks and bonds are kept at a predetermined ratio. That is, when compiling a portfolio, an investor may decide that 60% of its value will consist of bonds and 40% will be stocks. When prices rise or fall on the securities in the portfolio, the investor will buy and sell accordingly in order to maintain the ratio. A constant ratio plan is a form of active management and is done in order to reduce the risk in the portfolio.

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Stock Price

( Rs.)

Value of Conservative Portfolio (Rs. Lakh

Value of Aggressive Portfolio (Rs. Lakh)

Total value of portfolio

(Rs. Lakh)

Ratio Buy & Sell securities.

Total no. of shares in aggr. portfolio

20.00 5.00 5.00 10.00 1.00 25000

21.00 5.00 5.25 10.25 1.05 25000

22.00 5.00 5.50 10.50 1.10 25000

22.00 5.25 5.25 10.50 1.00 Sell 114 shares at Rs. 22.00

23860

21.00 5.25 5.01 10.26 0.95 23860

20.00 5.25 4.77 10.02 0.91 23860

19.80 5.25 4.72 9.97 0.91 23860

19.80 4.98 4.98 9.97 1.00 Buy 133 shares at Rs.19.80

25190

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Methodology adopted by Variable Ratio Plan

• In this investor should sell the stock when the price of stock rises and bond should be purchased. When stock prices fall they should be bought and the bonds should be sold.

• If the stock prices move upward it would be good to hold 30 % of stocks in equity and 70% in fixed income securities.

• In variable ratio, the ratio can be adjusted to suit every investor.

• The investor under this formula plan will have to make forecasts in the range of fluctuations which move both above and below the median to find out the different ratios at different levels of stock.

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• These stocks will have to be predicted with the absolute accuracy or the investor will not succeed in making profits. He will be left with the large number of stocks when the prices are falling or either he will find himself without any stocks when prices are rising.

• The most important tool in this is “forecasting”• This plan is most profitable or an investor when there

are large number of fluctuations.• Under this plan, the ratios are varied whenever there

is a change in the economic or market index. The most important factor after forecasting is that this plan takes into consideration “change”.

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Rupee Cost Average

• This is technique which is studied for those investors who do not have a sum of investment but who would require to build a fund and invest some money for a future date. Under this, the investor should continuously invest sum of rupees in a specified stock of specified portfolio at periodic differences.

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Example• A look at the table shows how investing regularly can

fetch you more shares of a stock through rupee cost averaging. In the above example, when investing in lump sum, the share price was Rs 20 -- meaning, you end up buying 500 shares.

• Instead, if one were to invest Rs 1,000 every month for 10 months, the total number of shares purchased adds up to 520, since these were bought at different price levels and the average cost of each share comes down to Rs 19.6.

• And 520 shares would definitely fetch a higher return than 500 at the end of ten months.

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Time (mths) Fixed amount invested (Rs) Price per share (Rs) Shares purchased

1 1000 20 50

2 1000 21 48

3 1000 24 42

4 1000 19 53

5 1000 16 63

6 1000 17 59

7 1000 16 63

8 1000 23 43

9 1000 18 56

10 1000 22 45

TOTAL 10,000 19.6 520