Notes Compiled by Prof.V.S.

Gopal

PORTFOLIO REVISION
In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which lads to the construction of the optimal portfolio. Very little discussion is seen on portfolio re ision which is as important as portfolio analysis or selection. !he financial mar"ets are continually changing. In this dynamic en ironment, a portfolio that was optimal when constructed may not be so with the passage of time. It may ha e to be re ised periodically so as to ensure that it remains optimal.

NEED FOR REVISION

!he primary factor necessitating portfolio re ision is changes in the financial mar"ets since the creation of the portfolio. !he need for portfolio re ision may arise because of some in estor related factors also. !hese factors may be listed as# $ ailability of additional funds for in estment. Change in ris" tolerance Change in in estment goals Need to li%uidate a part of the portfolio to pro ide funds for some alternati e use.

!he portfolio needs to be re ised to accommodate the changes in the in estor&s position. !hus the need for portfolio re ision may arise from changes in the financial mar"et or changes in the in estor&s position, namely, his financial status and preferences. .

MEANING OF PORTFOLIO REVISION

$ portfolio is a mix of securities selected from a ast uni erse of securities. !wo ariables determine the composition of a portfolio' the first is the securities included in the portfolio and the second is the proportion of total funds in ested in each security.

Notes Compiled by Prof.V.S.Gopal Portfolio re ision in ol es changing the existing mix of securities. !his may be effected either by changing the securities currently included in the portfolio or by altering the proportion of funds in ested in the securities. New securities may be added to the portfolio or some of the existing securities may be remo ed from the portfolio. Portfolio re ision thus leads to the purchases and sales of the securities. !he ob(ecti e of portfolio re ision is the same as selection i.e. maximi)ation of returns for a gi en le el of ris" or minimi)ing the ris" for a gi en le el of return. !he ultimate aim of portfolio re ision is maximi)ation of returns and minimi)ation of ris".

CONSTRAINTS IN PORTFOLIO REVISION

Portfolio re ision is the process of ad(usting the existing portfolio in accordance with the changes in the financial mar"ets and the in estor&s position so as to ensure maximum return from the portfolio with the minimum of ris". Portfolio re ision necessitates purchase and sale of securities. !he practice of portfolio ad(ustment in ol ing purchase and sale of securities gi es rise to certain problems which act as constraints in portfolio re ision. Some of these are discussed below# Transaction cost: *uying and selling of securities in ol e transaction costs such as commission and bro"erage. +re%uent buying and selling of securities for portfolio re ision may push up transaction costs thereby reducing the gains from portfolio re ision. ,ence, the transaction costs in ol ed in portfolio re ision may act as a constraint to timely re ision of portfolios. Taxes: !ax is payable on the capital gains arising from sale of securities. -sually, long.term capital gains are taxed at a lower rate than short.term capital gains. !o %ualify as long.term capital gain, a security must be held by an in estor for a period of not less than /0 months before sale. +re%uent sale of securities in the course of periodic portfolio re ision or ad(ustment will result in short.term capital gains, which would be taxed at a higher rate compared to long.term capital gains. !he higher tax of short.term capital gains may act as a constraint to fre%uent portfolio re isions.

Notes Compiled by Prof.V.S.Gopal

Statutory stipu ations: !he large portfolios in e ery country are managed by in estment companies and mutual funds. !hese institutional in estors are normally go erned by certain statutory stipulations regarding their in estment acti ity. !hese stipulations often act as constraints in timely portfolio re ision.

Intrinsic !i""icu ty: Portfolio re ision is a difficult and a time consuming exercise. !he methodology to be followed for portfolio re ision is also not clearly established. 1ifferent approaches may be adopted for the purpose. !he difficulty of carrying out portfolio re ision itself may act as a constraint to portfolio re ision.

PORTFOLIO REVISION STRATEGIES

!wo different strategies may be adopted for portfolio re ision, namely, an acti#e re#ision strate$y and a passi#e re#ision strate$y. !he choice of the strategy would depend on the in estors ob(ecti es, s"ills, resources and time. $cti e re ision strategy in ol es fre%uent and sometimes substantial ad(ustments to the portfolio. In estors who ta"e acti e re ision strategy belie e that the securities mar"ets are not continuously efficient. !hey belie e that the securities can be mispriced at times gi ing an opportunity for earning excess returns through trading in them. 2oreo er, they belie e that different in estors ha e di ergent expectations regarding the ris" and return of the securities in the mar"et. !he practitioners of the acti e re ision strategy are confident of de eloping a better estimate of the true ris" and return of the security than the rest of the mar"et. !hey hope to use their better estimated to generate excess returns. !hus the ob(ecti e of acti e re ision strategy is to beat the mar"et. Portfolio re ision strategy, in contrast, in ol es only minor and infre%uent ad(ustments to the portfolio o er time. !he practitioners of passi e re ision strategy belie e in mar"et efficiency and homogeneity of expectation among in estors. !hey find little incenti e for acti ely trading and re ising portfolios practically.

Notes Compiled by Prof.V.S.Gopal -nder passi e re ision strategy, ad(ustment to the portfolio is carried out according to certain predetermined rules and procedures designated as +ormula Plans. !hese +ormula Plans help the in estor to ad(ust his portfolio according to changes in the securities mar"et.

FORM%LA PLANS:
In the mar"et the prices of securities fluctuate. Ideally, in estors should buy when prices are low and sell when prices are high. If portfolio re ision is done according to this principle, in estors would be able to benefit from the price fluctuations in the securities mar"et. *ut in estors are hesitant to buy when prices are low either expecting the prices to fall further or fearing that the prices would not mo e further up again. Similarly, when prices are high, in estors hesitate to sell because they feel that the prices will fall further and they may reali)e larger profits. !hus, left to themsel es, in estors will not be acting in a way re%uired to benefit from price fluctuations. ,ence certain mechanical re ision techni%ues ha e been de eloped to enable the in estor to ta"e ad antage of the price fluctuations in the mar"et. !he techni%ue is referred as For&u a P ans' +ormula plans represent an attempt to exploit the price fluctuations in the mar"et and ma"e them a source of profit to the in estor. !hey ma"e the decisions on the timing of buying and selling securities automatically and eliminate the emotions surrounding the timing decisions. +ormula plans consist of predetermined rules regarding when to buy or sell and how much to buy and sell. !hese predetermined rules call for specific actions when there are changes in the securities mar"et. !here are different formula plans for implementing passi e portfolio re ision. Some of them are enumerated below# .

Constant Rupee Va ue P an:

!his is one of the most commonly used formula plans. In this plan the in estor constructs two portfolios, one aggressi e consisting of e%uity shares and the other one defensi e consisting of bonds and debentures. !he purpose of this plan is to "eep the alue of the

Notes Compiled by Prof.V.S.Gopal aggressi e portfolio constant, i.e. at the original amount in ested in the aggressi e portfolio. $s share prices fluctuate, the alue of the aggressi e portfolio "eeps changing. 3hen share prices are increasing, the total alue of the aggressi e portfolio increases. !he in estor has to sell some of his shares from his portfolio to bring down the total alue of the aggressi e portfolio to the le el of his original in estment in it. !he sale proceeds will be in ested I the defensi e portfolio by buying bonds and debentures 4n the contrary, when share prices are falling, the total alue of the aggressi e portfolio would also decline. !o "eep the total alue of the aggressi e portfolio at its original le el, the in estor has to buy some shares from the mar"et to be included in his portfolio. +or this purpose, a part of the defensi e portfolio will be li%uidated to raise the money needed to buy additional shares. -nder this plan, the in estor is effecti ely transferring funds from the aggressi e portfolio to the defensi e portfolio and thereby boo"ing profit when share prices are increasing. +unds are transferred from the defensi e portfolio to the aggressi e portfolio when share prices are low. !hus the plan helps the in estor to buy shares when their prices are low and sell them when their prices are high. In order to implement this plan, the in estor has to decide the action points, i.e., when he should ma"e the transfer of funds to "eep the rupee alue of the aggressi e portfolio constant. !hese action points, or re ision points, should be predetermined and should be chosen carefully. !he re ision points ha e a significant effect on the returns of the in estor. +or instance, the re ision points may be predetermined as /5 per cent, /6 per cent, 05 per cent etc. abo e or below the original in estment in the aggressi e portfolio. If the re ision points are too close, the number of transactions would be more and the transaction costs would increase reducing the benefits of re ision. If the re ision points are set too far apart, it may not be possible to profit from the price fluctuations occurring between these re ision points.

Notes Compiled by Prof.V.S.Gopal Exa&p e: 3e can understand the wor"ing of the (constant rupee #a ue p an) by considering an example. 7et us consider an in estor who has 8s. /,55,555 for in estment. ,e decides to in est 8s. 65,555 in an aggressi e portfolio of e%uity shares and the remaining 8s. 65,555 in a defensi e portfolio of bonds and debentures. ,e purchases /065 shares selling at 8s. 95 per share for his aggressi e portfolio. !he re ision points are fixed as 05 per cent abo e or below the original in estment of 8s. 65,555. $fter the construction of the portfolios, the share price will fluctuate. If the price of the share increases to 8s. 96, the alue of the aggressi e portfolio increases to 8s. 6:,065 ;that is, /065 x 8s. 96<. Since the re ision points are fixed at 05 per cent abo e or below the original in estment, the in estor will act only when the alue of the aggressi e portfolio increases to 8s. :5,555 or falls to 8s. 95,555. If the price of the share increases to 8s. 9= or abo e, the alue of the aggressi e portfolio will exceed 8s. :5,555. 7et us suppose that the price of the share increases to 8s. 65, the alue of the aggressi e portfolio will be 8s. :0,655. !he in estor will sell shares worth 8s. /0,655 ;that is 065 shares at 8s. 65 per share< and transfer the amount to the defensi e portfolio by buying bonds for 8s. /0,655. !he alue of the aggressi e and defensi e portfolios would now be 8s. 65,555 and 8s. :0,655 respecti ely. !he aggressi e portfolio now has only /555 shares alued at 8s. 65 per share. 7et us now suppose that the share price falls to 8s. 95 per share. !he alue of the aggressi e portfolio would then be 8s. 95,555 ;i.e., /555 shares x 8s. 95< which is 05 per cent less than the original in estment. !he in estor now has to buy shares worth 8s. /5,555 ;that is, 065 shares at 8s. 95 per share< to bring the alue of the aggressi e portfolio to its original le el of 8s. 65,555. !he money re%uired for buying the shares will be raised by selling bonds from the defensi e portfolio. !he two portfolios now will ha e alues of 8s. 65,555 ;aggressi e< and 8s. 60,655 ;i.e., 8s. :0,655 . 8s. /5,555< ;defensi e<, aggregating to 8s. /,50,655. It may be recalled that the in estor started with 8s. /,55,555 as in estment in the two portfolios. !hus, when the >constant rupee alue plan? is being implemented, funds will be transferred from one

Notes Compiled by Prof.V.S.Gopal portfolio to the other, whene er the alue of the aggressi e portfolio increases or declines to the predetermined le els.

Constant Ratio P an
!his is a ariation of the constant rupee alue plan. ,ere again the in estor would construct two portfolios, one aggressi e and the other defensi e with his in estment funds. !he ratio between the in estments in the aggressi e portfolio and the defensi e portfolio would be predetermined such as /#/ or /.6#/ etc. !he purpose of this plan is to "eep this ratio constant by read(usting the two portfolios when share prices fluctuate from time to time. +or this purpose, a re ision point will also ha e to be predetermined. !he re ision points may be fixed as @ 5./5 for example. !his means that when the ratio between the alues of the aggressi e portfolio and the defensi e portfolio mo es up by 5./5 points or mo es down by 5./5 points, the portfolios would be ad(usted by transfer of funds from one to the other. 7et us assume that an in estor starts with 8s. 05,555, in esting 8s. /5,555 each in the aggressi e portfolio and the defensi e portfolio. !he initial ratio is then /#/. ,e has predetermined the re ision points as @ 5.05. $s share price increases the alue of the aggressi e portfolio would rise. 3hen the alue of the aggressi e portfolio rises to 8s. /0,555, the ratio becomes /.0#/ ;i.e., 8s. /0,555# 8s. /5,555<. Shares worth 8s. /,555 will be sold and the amount transferred to the defensi e portfolio by buying bonds. Now the alue of both the portfolios would be 8s. //,555 and the ratio would become /#/. Now let us assume that the share prices are falling. !he alue of the aggressi e portfolio would start declining. If, for instance, the alue declines to 8s. =,655, the ratio becomes 5.AA#/ ;i.e., 8s. =.655# 8s. /,555<. !he ratio has declined by more than 5.05 points. !he in estor now has to ma"e the alue of both portfolios e%ual. ,e has to buy shares worth 8s. /,065 by selling bonds for an e%ui alent amount from his defensi e portfolio. Now the alue of the aggressi e portfolio increases by 8s. /.065 and that of the defensi e portfolio decreases by 8s. /,065. !he alues of both portfolios become 8s. B,A65 and the ratio becomes /#/.!he ad(ustment of portfolios is done periodically in this manner.

Notes Compiled by Prof.V.S.Gopal

Do ar Cost A#era$in$
!his is another method of passi e portfolio re ision. !his is, howe er, different from the two +ormula Plans discussed abo e. $ll +ormula Plans assume that stoc" prices fluctuate up and down in cycles. 1ollar cost a eraging utili)es this cyclic mo ement in share prices to construct a portfolio at low cost. !he Plan stipulates that the in estor in est a constant sum, such as 8s. 6,555, 8s. /5,555, etc, in a specified share or portfolio of shares regularly at periodical inter als, such as a month, two months, a %uarter, etc. regardless of the price of the shares at the time of in estment. !his periodic in estment is to be continued o er a fairly long period to co er a complete cycle of share price mo ements. If the Plan is implemented o er a complete cycle of stoc" prices, the in estor will obtain his shares at a lower a erage cost per share than the a erage price pre ailing in the mar"et o er the period. !his occurs because more shares would be purchased at lower prices than at higher prices. !he 1ollar Cost $ eraging is really a techni%ue of building up a portfolio o er a period of time. !he Plan does not en isage withdrawal of funds from the portfolio in between. 3hen a large portfolio has been built up o er a complete cycle of share price mo ements, the in estor may switch o er to one of the other formula plans for its subse%uent re ision. !he Cdollar cost a eragingD is specially suited to in estors who ha e periodic sums to in est. !he arious formula plans attempt to ma"e portfolio re ision a simple and almost

mechanical exercise enabling the in estor to automatically buy shares when their prices are low and sell them when their prices are high. *ut formula plans ha e their limitations. *y their ery nature they are inflexible. +urther, these plans do not indicate which

Notes Compiled by Prof.V.S.Gopal securities from the portfolio are to be sold and which securities are to be bought to be included in the portfolio. 4nly acti e portfolio re ision can pro ide answers to these %uestions