In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which leads to the construction of the optimal portfolio. Portfolio revision is important as portfolio analysis and selection.
The financial markets are continually changing. In this dynamic environment, a portfolio that was optimal when constructed may not continue to be optimal with the passage of time.
It may have to be revised periodically so as to ensure that it continues to be optimal.
A portfolio is a mix of securities selected from a vast universe of securities.
Two variable determine the composition of a portfolio:
- The securities included in the portfolio, and
- The proportion of total funds invested in each security.
Meaning of Portfolio Revision
Portfolio revision involves changing the existing mix of securities.
This may be effected either by changing the securities currently included in the portfolio or by altering the proportion of funds invested in the securities.
New securities may be added to the portfolio or some o the existing securities may be removed from the portfolio. Portfolio revision thus leads to purchases and sales of securities.
The objective of portfolio revision is the same as the objective of portfolio selection like maximizing the return for a given level of risk or minimizing the risk for a given level of return.
The ultimate aim of portfolio revision is the maximization of returns and minimization of risk.
Objectives of Portfolio Revision
The objective o portfolio revision is the same as the objective of portfolio selection like maximizing the return for a given level of risk or minimizing the risk for a given level of return.
The ultimate aim of portfolio revision is:
- To maximize the returns and
- To minimize the risk.
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Need for Portfolio Revision
The primary factor necessitating portfolio revision is changes in the financial markets since the creation of the portfolio.
The need for portfolio revisions may arise some because of some investor-related factors also. These factors may be listed as:
- Availability of additional funds for investment.
- Change in risk tolerance.
- Change in investment goals.
- Need to liquidate a part of the portfolio to provide funds for some alternative use.
The portfolio needs to be revised to accommodate the changes in the investor’s position.
Thus, the need for portfolio revision may arise from changes in the financial market or changes in then investors’ position, namely his financial status and preferences.
Constraints in Portfolio Revision
Portfolio revision or adjustment necessitates purchases and sale of securities.
The practice of portfolio adjustment involving purchase and sale of securities gives rise to certain problems that act as constraints in portfolio revision. Some of these are as follows:
1. Transaction Cost
Buying and selling securities involve transaction costs such as commission and brokerage.
Frequent buying and selling of securities for portfolio revision may push up transaction costs thereby reducing the gains from portfolio revision.
Hence, the transaction costs involved in portfolio revision may act as a constraint to the timely revision of the portfolio.
2. Taxes
Tax is payable on the capital gains arising from sales of securities.
Usually, long term capital gains are taxed at a lower rate than short term capital gains. To qualify as long term capital gain, a security must be held by an investor for a period of not less than 12 months before the sale.
Frequent sale of securities in the course of periodic portfolio revision or adjustments will result in short term capital gains which would be taxed at a higher rate compared to long term capital gains.
The higher tax on short term capital gains may act as a constraint to frequent portfolio revisions.
3. Statutory Stipulations
The largest portfolios in every country are managed by investment companies and mutual funds.
These institutional investors are normally governed by certain statutory stipulations regarding their investment activity.
These stipulations often act as constraints in timely portfolio revision.
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4. Intrinsic Difficulty
Portfolio revision is a difficult and time-consuming exercise.
The methodology to be followed for portfolio revision is also not clearly established.
Different approaches may be adopted for the purpose. The difficulty of carrying out revision itself may act as a constraint to portfolio revision.
Portfolio Revision Strategies
Two different strategies may be adopted for portfolio revisions which are as follows:
1. Active Revision Strategy
Active revision strategy involves frequent and sometimes substantial adjustments to the portfolio.
Active portfolio revision is essentially carrying out portfolio analysis and portfolio selection all over again.
It is based on an analysis of the fundamental factors affecting the economy, industry, and company has also the technical factors like demand and supply.
Consequently, the time, skill, and resources required for implementing an active revision strategy will be much higher.
The frequency of trading is likely to be much higher under active revision strategy resulting in higher transaction costs.
2. Passive Revision Strategy
A passive revision strategy, in contrast, involves only minor and frequent adjustments to the portfolio over time.
The practitioners of passive revision strategy belive in market efficiency and homogeneity of expectation among investors. They find a little incentive for actively trading revising portfolios periodically.
Under passive revision strategy, adjustment to the portfolio is carried out according to certain predetermined rules and procedures designed as formula plans.
These formula plans help the investor to adjust his portfolio according to changes in the securities market.
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Formula Plan
Formula plans presume that portfolios differ in their characteristics and, to a large extent, are capable of reducing unique security risks through a combination of negatively related securities in a portfolio.
Portfolios usually have a composition of “less riskless return” securities as well as “high-risk high return” securities.
The less riskless return combination can be termed as the conservative component of a portfolio while the high-risk high return securities can be categorized as an aggressive component of a portfolio.
The latter component of portfolios is usually construed with shares of companies while the conservative component holds mostly fixed return securities such a debt and treasury bonds.
Portfolio revision, besides changing the individual security selection, also considers the total quantum investment in a conservative or aggressive component.
The subdivision is also often made depending on the objectives of the portfolios. A portfolio with growth objectives would have a major aggressive component.
On the other hand, a portfolio with regular assured income would have a major subdivision of conservative investment.
The formula plan helps in distributing funds between these types of portfolio components since the aggressive and conservative components are expected to behave in an inverse fashion at any specific point of time.
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Assumptions of Formula Plan
Following are the assumptions of formula plan:
- The first assumption is that a 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% to bonds and 20% to stocks in the portfolio. If the market is low, the proportion may reverse. In a balanced fund, 50% of the fund is invested in stocks and 50% 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 the market could be measured with the help of indices like BSE Sensex and NSE Nifty.
- The fourth assumption requires that the investor should strictly follow the formula plan once he chooses it. He should not abandon the plan but continue to act on the plan.
- The investor 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 fundamentally strong companies have to be included in the portfolio.
Types of Formula Plan
Portfolio revision considers the change in the structure and composition of shares in the portfolio.
It might involve a simple revision of weights of the shares or the inclusion or dropping of a share to or from the portfolio.
Portfolio revision can be studied under the following formula plans:
1. Rupee Cost Averaging Plan
Rupee cost averaging relies on the mathematical advantage of “averaging out”.
Here investors are buyers in the market. Irrespective of a fall or rise in prices, the investors intend to purchase the shares. This plan is used most often for portfolio building.
The method of buying the shares depends on the rise or fall in prices. When there is a fall in the price of a share, it is purchased in larger quantities.
The intention is to increase the wealth of the investors rather than secure returns for the investors. For enlarging this portfolio, investors may identify a certain percentage of increment or decrement.
Advantages of Rupee Cost Averaging Plan
- 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 plan the investment program 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 declining market.
Disadvantages Rupee Cost Averaging Plan
- Extra Transaction costs are involved with the small and frequent purchases 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 individual stocks that are to be purchased.
- There is no indication of the appropriate interval between purchases.
- The averaging advantages do not yield a profit if the stock price is in a downward trend.
- The plan seems to work better when stock prices have cyclical patterns.
2. Constant Value Plan
The objective of the constant rupee plan is to balance the division between the conservative and aggressive components of a portfolio in terms of the target value. The target value could be fixed initially by the investor in a desirable proportion.
For example, a constant rupee plan could consider the initial value of 10000 each between conservative and aggressive portfolios. There can also be an initial value of 15000 and 5000 in the aggressive and conservative portfolio components respectively.
Subsequently, changes in the portfolio components would cause a revision or shift of funds from one component to the other.
The target portfolio value in the aggressive component could be fixed to the initial value and the excess shifted to the conservative portfolio.
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Similarly, a shortfall in the aggressive components is set right using ng the funds in the conservative portfolio.
The purpose of the constant rupee plan is to maintain the total value of the aggressive portfolio at a consistent level.
To achieve this, the investor can monitor the changes in the portfolio component and fix the percentage change in price that would require a portfolio revision.
Advantages of Constant Value Plan
The advantage of a constant ratio plan is the automatism with which it forces the managers to counter adjust their portfolio cyclically.
But this approach does not eliminate the necessity of selecting individual security.
Disadvantages of Constant Value Plan
The limitation of the plan is that the money is shifted from the stock portion to the bond portion.
Bond is also a capital market instrument and responds to market pressures. Bond and share prices may both rise and fall at the same time. In the downtrend, both prices may decline and then gain.
3. Variable Ratio Plan
The variable-ratio plan gives more flexibility to the investor to revise the portfolio components.
When the share price falls, the investor may shift a major component of the conservative portfolio to the aggressive component.
The desired ratio of investment holding between conservative and aggressive components of a portfolio hence may vary according to the flexibility that the investor wishes to incorporate in the portfolio revision decisions.
When the share price rises back, then the investor may shift funds back to maintain a stabilized portfolio.
Advantages of Variable Ratio Plan
Automatically, the investor tends to correct his portfolio according to the price changes.
The investor is not emotionally affected by the price changes in the market.
With an accurate forecast, the variable-ratio plan takes grater advantage of price fluctuations than the constant ratio plan.
Disadvantages of Variable Ratio Plan
- The investor has to construct the appropriate zones and trends for the alteration of the proportions.
- The selection of security has to be done by the investor by analyzing the merits of the stock. The plan does not help in the selection of scrips.
- If the zones are too small frequent changes have to be done and it would limit portfolio performance.
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