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What is formula plan in Portfolio Revision?
Formula plans consist of the basic rules and regulations for purchasing and selling investments. Formula plans enable the investors to estimate the total amount that he has to spend on purchase of securities. Investors may become emotional and they may not act rationally while making investments. Investors can earn superior profit by using formula plan.
The formula plan gives a path or course of action within the framework of the investment objectives of the investor. The investor can easily act according to the formula given to him without experiencing the problem of forecasting fluctuations in the future stock prices. The investor is safeguarded against any possible loss resulting from portfolio construction.
Advantages of the formula plan
Formula plans offer the following advantages to the investors:
1. The investor obtains basic rules and regulations for purchase and sale of securities.
2. The rules and regulations laid down by the formula plans are rigid and they enable the investors to overcome emotions and make rational decisions.
3. The investors can earn higher income from their portfolio by adopting formula plans.
4.. A course of action is determined in the light of the objectives of the investors.
5. The investor is able to control buying and selling of securities.
6. Formula plans are helpful in making decisions on the timing of investment.
Disadvantages of formula plans
1. The formula plans do not help in the selection of security. The selection of security is based on the fundamental or technical analysis.
2. Formula plans are highly rigid.
3. The formula plans can be applied for long periods, otherwise the transaction cost will be high.
4. Formula plans do not help the investors make forecasts of market movements. Without such forecasts best stocks cannot be identified.
Formula Plan Rules
The formula plans lay down the following rules for construction of an optimal portfolio.
1. The formula plans help investors make a decision on the timing of investment. Securities will be selected on the basis of methodology related to the economic, industry and company framework.
2. Basically, the formula plans are highly rigid. The investor, while following the rigid rules of formula plans will experience some problems of adjustment with changing environmental conditions.
3. The formula plans work fruitfully only for long period of holding of securities.
4. The formula plans do not obviate the need for making forecast.
5. Each formula plan has its own methodology of working.
Implementation of formula plan
The formula plans are formulated only when the investor has a pool of funds which he wants to invest in securities. The investor should hold two portfolios namely,
- aggressive portfolio; and
- conservative portfolio.
The aggressive portfolio will have large number of fluctuations whereas the conservative portfolio which is comprised of bonds will be defensive in nature. The conservative portfolio is intended to complement the aggressive portfolio.
If the stock prices remain constant, profits will not be available. Only when stock prices fluctuate frequently, investors can make profit out of such price fluctuations. The investor before implementing formula plans should equip himself with the historical movement of prices.