Assumptions of the Formula Plan

Assumptions of the Formula Plan

The first assumption is that certain percentage of the investor’s fund is allocated to fixed income securities and common stocks The proportion of money invested in each component depends on the prevailing market condition. If the stock market is in the boom condition lesser funds are allotted to stocks. Perhaps it may be a ratio of 80 per cent to bonds and 20 per cent to stocks in the portfolio. If the market is low, the proportion may reverse. In a balanced fund, 50 per cent of the fund is invested in stocks and 50 per cent in bonds.

The second assumption is that if the market moves higher, the proportion of stocks in the portfolio may either decline or remain constant. The portfolio is more aggressive in the low market and defensive when the market is on the rise.

The third assumption is that the stocks are bought and sold whenever there is a significant change in the price. The changes in the level of market could be measured with the help of indices like BSE-Sensitive Index and NSE-Nifty.

The fourth assumption requires that the investor should strictly follow the formula plan once lie chooses it. He should not abandon the plan but continue to act on the plan.

The investors should select good stocks that move along with the market. They should reflect the risk and return features of the market. The stock price movement should be closely correlated with the market movement and the beta value should be around 1.0. The stocks of the fundamentally strong companies have to be included in the portfolio.

Advantages of the Formula Plan

Basic rules and regulations for the purchase and sale of securities are provided.

The rules and regulations are rigid and help to overcome human emotion.

The investor can earn higher profits by adopting the plans.

A course of action is formulated according to the investor’s objectives

It controls the buying and selling of securities by the investor.

It is useful for taking decisions on the timing of investments.

Disadvantages

The formula plan does not help the selection of the security. The selection of the security has to be done either on the basis of the fundamental or technical analysis.

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 investor adopts the formula plan, he needs forecasting. Market forecasting helps him to identify the best stocks.

Rupee Cost Averaging

The simplest and most effective formula plan is rupee cost averaging. First, stocks with good fundamentals and long term growth prospects should be selected. Such stocks’ prices tend to be volatile in the market and provide maximum benefit from rupee cost averaging. Secondly, the investor should make a regular commitment of buying shares at regular intervals. Once he makes a commitment, he should purchase the shares regardless of the stock’s price, the company’s short term performance and the economic factors affecting the stock market.

In the rupee cost averaging plan, the investor buys varying number of shares at various points of the stock market cycle. In a way, it can be called time diversification. Let us assume that an investor decides to buy Rs11000 worth of particular shares for four quarters in one particular year, ignoring the transaction costs. The details are given in table

In the above example, the stock price fell in the second quarter but recovered in the third quarter. The investor was able to buy more stocks in the second quarter than in the first quarter. The benefits of this policy can be viewed by comparing the last two columns. In the second quarter, the average cost per share is lower than the average market price per share. This is the benefit derived from rupee cost averaging.

The rupee cost averaging for the Hero Honda stock is given in table. The process of investment is assumed to commence in January 1996 and end in 1998, covering 12 quarters.

Advantages

The advantages of the rupee cost averaging plan are

Reduces the average cost per share and improves the possibility of gain over a long period.

Takes away the pressure of timing the stock purchase from investors

Makes the investors to plan the investment programme thoroughly on the commitment of funds that has to be done periodically

Applicable to both falling and rising market, although it works best if the stocks are acquired in a declini1ig market.

In a nut shell, the investor must decide in advance the sum and periodic intervals at which he has to invest. Once it is decided, the implementation is mechanical.

Limitations

Extra transaction costs are involved with small and frequent purchase of shares

The plan does not indicate when to sell. It is strictly a strategy for buying

It does not eliminate the necessity for selecting the individual stocks that are to be purchased

There is no indication of the appropriate interval between purchases

The averaging advantage does not yield profit if the stock price is in a downward trend

The plan seems to work better when stock prices have cyclical patterns.

The rupee cost averaging plan yields better results when applied to no load mutual funds. The problems of high transaction costs and stock selection are eliminated. The broad based index fund experiences profit if the once is volatile, allowing the averaging effect to result in cost reduction. The investor has only to decide on the size of the fund and the length of the interval between the purchases.