Investing

Formula Investment Plans

Speculating in the market is not always limited to those who have a lot of money. With some skillful manipulation of your portfolio, you can use formula plans to help you speculate with small amounts of money.

What Are Formula Investment Plans?

A formula investment plan is a systematic method of portfolio management. Formula plans divide an investor’s portfolio into two portions: speculative and conservative. There are a number of formula investment plans that can help you do this. Two such plans are the constant-dollar plan and the constant-ratio plan.

Two parts to a plan

Often, formula plans divide an investor’s portfolio into two portions: speculative and conservative. The speculative portion contains aggressive, volatile securities with the potential to earn large returns or create significant losses. The conservative portion holds less-volatile securities—such as government bonds—that are expected to grow slowly but steadily.

What investors should do

Formula investors carefully monitor the speculative portions of their portfolios. As this component changes in value, investors add to, or reduce, their positions to maintain a pre-determined level of ownership of speculative securities. This level of ownership is simply measured in dollars in a constant-dollar plan. In contrast to that, a constant-ratio plan maintains a set percentage of the overall portfolio value in speculative securities.

What are constant-dollar plans?

In a constant-dollar plan, the investor divides his or her investment portfolio as described above, then establishes a specific dollar amount for the portfolio’s speculative portion that he has established, and puts the rest of the funds into the more conservative portion. The investor then sets "trigger points" slightly above and below the constant-dollar amount. When market movements cause the dollar value of the speculative portion of the portfolio to rise or fall past a trigger point, the portfolio is rebalanced, so the dollar amount invested in the speculative assets remains constant.

An example

Let’s say an investor wishes to maintain $1,000 of his portfolio in a speculative high-tech stock. If the price of the stock is $10 a share, that’s 100 shares of the stock. If the price rises to $20 a share, the investor will own $2,000 of stock. To maintain his constant-dollar plan, the investor will sell 50 shares ($1,000) and reinvest the gains in more conservative investments, such as Treasury bonds.

Conversely, if the value of the high-tech stock falls below the desired trigger point, the investor will sell some of the conservative investments and buy more shares of the tech stock.

What are constant-ratio plans?

In a constant-ratio plan, the investor divides his or her investment portfolio as described above, then establishes a constant ratio between the speculative and conservative portions of the portfolio. When the ratio between the two sides differs very much from the desired ratio, the investor rebalances his or her portfolio.

When the speculative part of the portfolio falls below the set ratio, funds are added to it from the conservative portion. When the speculative securities rise in value, some are sold and the proceeds are reallocated to increase the value of the conservative portion.

A formula investment plan is a systematic method of portfolio management.
Formula plans divide an investor’s portfolio into two portions: speculative and conservative.

An example

Suppose an investor wishes to keep 10 percent of his $10,000 portfolio in stock XYZ. That means he has $1,000 of it. But what happens if the value of the whole portfolio rises to $20,000? The investor now adjusts his shares of stock XYZ to a value of $2,000 worth, or 10 percent of $20,000.

Formula investment plans are a way to help investors monitor and guide their speculation with systematic strategies that can reduce risk and maintain steadier returns. Before you can effectively use one of these plans, you must choose an amount or percentage of your portfolio to devote to speculation. This is an important decision, not to be made lightly.

Disclosures