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Formula plans are certain predefined rules and regulations deciding when and how much
assets an individual can purchase or sell!
In other words, the formula plan provides the basic rules and regulations for the purchase
and sale of securities.
Formula plans help an investor to make the best possible use of fluctuations in the financial market !!
With the help of formula plan an investor can divide his funds
into defense portfolio and aggressive and easily transfer from one portfolio to
other.
But what is Defense and Aggressive Portfolio?
It consists of funds that appreciate quickly and guarantee maximum returns to the investor.
In simple terms,
High risk - High Return!
It consists of securities that do not fluctuate much and remain
constant over a period of time.
The focus here is GROWTH!
The First Assumption
Certain percentage of the investor’s fund is allocated to fixed income
securities and common stocks.
The Second Assumption
If the market moves higher, the proportion of stocks in the portfolio
may either decline or remain constant.
The Third Assumption
The stocks are bought and sold whenever there is a significant change in
the price.
The Fourth Assumption
The investor should strictly follow the formula plan once he
chooses it.
Higher Profits - Investor can earn higher profits
Rules & Regulations - Basic rules and regulations for the purchase and sale of securities are provided.
Overcome Human Emotion - The rules and regulations are rigid and help to overcome human emotion.
Objective Oriented- A course of action is formulated according to the investor’s objective.
Provides Control - It controls the buying and selling of securities by the investor.
Decision Making - It is useful for taking decision on the timing of investments.
The formula plan does
not help the selection of the security.
It is strict and not
flexible with the inherent problem of adjustment.
The formula plan should
be applied for long periods, otherwise the transaction cost may be high.
Even if the investors
adopts the formula plan, the investors need to perform forecasting which might be tedious.
Advantages
Reduces the average cost per share
Takes away the pressure of timing the stock purchase from investor
Advantages and Disadvantages
Disadvantages
Extra transaction cost
Does not indicate when to sell
No indication of interval between purchases
Stocks with good fundamentals and long-term growth prospects should be selected.
Those Stocks will provide the maximum benefit.
The investor should make a regular commitment to buy shares.
They should buy those shares regardless of the prices, short term performance.
Advantages
Purchases and Sales are determined automatically
Helps in higher profit
Advantages and Disadvantages
Disadvantages
Investor should be rational in buying and selling
Plan forces investors to sell when prices rise and sell when prices fall
The portfolio is divided into two parts, one aggressive part and another conservative part
When the price of the stock increases the investor sells sufficient amount to return to the original amount of investment
By keeping the value of aggressive portfolio constant, reminder is invested in conservative portfolio
Advantages
Helpes the investor counter adjust their portfolio cyclically depending on the market
Advantages and Disadvantages
Disadvantages
The money might be shifted from stock portion to bond portion which can cost growth
Attempt to maintain a constant ratio between aggressive
and conservative portfolios.
The ratio is fixed by the investor. The investor’s
attitude towards risk and return plays a major role in fixing the ratio.
The
conservative investor may like to have more of bond the aggressive investor,
more of stocks.
Once the ratio is fixed, it is maintained as the market moves
up and down.
Advantages
Automatically the investor tends to correct his portfolio
With accurate forecast the variable ratio plan takes greater
advantage of price fluctuations
Advantages and Disadvantages
Disadvantages
The investor has to
construct the appropriate zones and trend for alterations of the proportions.
If the zones are too small frequent changes have to be done and
it would limit portfolio performance
According to this plan, at varying levels of market prices, the
proportions of the stocks and bonds change.
Whenever the price of the stock
increases, the stocks are sold and new ratio is adopted by increasing the
proportion of defensive portfolio.
To adopt this plan, the investor is required
to estimate a long term trend in the price of the stocks.
Forecasting is very
essential to this plan.