Integrating Formula Plans Into Your Portfolio

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As set forth succinctly by one student, the basis of formula plans is: "If the problem of timing cannot be met by forecasting the cycle or by rejecting forecasting, what is to be done?"

Attempts have been made to protect investment funds against some of the losses from adverse fluctuations in security prices and to ensure that such funds will retain some of the profits from favorable fluctuations. The essence of such plans is that the investment fund shall at all times consist of two portions—a defensive fund consisting of securities having relatively small price fluctuations (high-grade bonds and preferred stocks) and an aggressive fund made up of securities having considerable price volatility (mainly common stocks). As security prices rise, the defensive portion of the fund is to be enlarged relative to the aggressive segment. As security prices decline, the aggressive portion is to be increased through transfer from the defensive section of the fund.

Important premises of these plans, "it is clear, are that security prices will continue to fluctuate and that the amplitude of fluctuation of some security prices will be greater than that of others, and that the direction of security price movements cannot be forecast accurately and consistently."

A few investment companies have adopted formula plans, and several colleges set up and followed a number of plans in the management of their portfolios. For illustration, two major classes of approach are outlined in summary fashion. The first approach requires starting from a stock market average, say Standard and Poor's index of 500 stocks, which includes industrial, public utility, and railroad stocks.

It is decided that 52 (1940 = 10) seems to be a reasonable point in the light of the record of earnings and dividends. We propose to reduce our common stock holdings by 10 percent when the average rises by 10 percent from this point and to add 10 percent to our common stock holdings whenever the average falls 10 percent.

The second plan proceeds as follows: We believe that for our purpose, it is desirable to have 60 percent of our fund in fixed-income securities and 40 percent in common stocks. Every 60 days, we will review our portfolio and cut back our common stock holdings if the value exceeds 40 percent of the total market value of the portfolio. Conversely, if the common stocks add up to less than 40 percent of the total, we will add sufficiently to bring up the aggregate value of common stocks to the 40 percent ratio.

The success of these plans requires, in large part, that the course of common stock prices proceed in wave-like movements.

If, perversely, stock prices continue to rise or fall without much interruption over a period of time, the formula plan will not work. Experience during the 1950s, when common stocks were sold several times and could not be bought back at lower prices, led to the abandonment of a number of formula plans.

Each investor must decide individually what portion, if any, of his portfolio should be invested in formula plans, but in general we have found them to be sound, safe investments.

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