Easing Yourself Into Constant-Ratio Formulas
The progression from constant-ratio formulas to variable ratios is completely logical. Once an investor understands the principles of constant-ratio planning, he might well wonder about the feasibility of adding some flexibility to a formula by increasing the ratio of common stocks when the market is low, and cutting back when the market is high, thus maximizing purchases of stock at low prices and minimizing risks at high levels.
This is precisely what the variable-ratio plans attempt to do. Understanding the objective is easy attaining it is somewhat less so. There have undoubtedly been more variable-ratio plans invented than any other type, and a high percentage of them have wound up in the ashcan. Some worked extraordinarily well over a period of time, and then became worthless because of changing conditions in the market. Others were obsolete almost as soon as devised. But variable ratios are by no means dead. On the contrary, at the present time there are probably more formulas of this type in use than any other.
The idea of increasing or decreasing the proportion of stocks (as the market crosses a predetermined point or moves into or out of a fixed “zone”) applies to all variable-ratio formulas. The 50-50 proportion specified at the median can be changed, according to the needs and tastes of the investor, with other proportionate changes up and down the scale. For example, an investor willing to build more risk into his plan might fix a 65 percent proportion of stocks at the median, ranging from 35 percent at high market levels to 95 percent at the lows.
Variable-ratio plans differ in specifying whether portfolio shifts are to be made when the market enters a “zone” of predetermined width, or when it crosses a point fixed in advance to signal a new stock-bond relationship. In any case, when the market average is between two action points or within the limits of a zone the portfolio is to be handled as under a constant-ratio plan, with the ratios determined by the rules of the variable-ratio formula. In the case of the “action point” method, where a ratio shift is indicated by a crossing of the point by a market average, different ratios are specified for the same market level, depending on whether the market crossed the point in an uptrend or a downtrend. This will become clearer as we examine some examples of variable ratios.
Another point on which plans differ is the question of the so-called “halfway rule.” This rule stipulates that no purchases or stocks are to be made above the median, and no sales of stocks are to be made below it. For example, in a hypothetical plan based on the diagram above, if the market average happened to rise 75 percent above the median, calling for a 20/80 stock-bond proportion, enough stocks would be sold to bring the percentage of stocks down to 20 percent.
If the average were then to fall to 50 percent above the median, theoretically calling for a 30/70 relationship, no stocks would be bought to bring the stock portion of the account up to the indicated 30 percent, if the halfway rule were in operation. No stock would be bought, in fact, unless the market average fell to the median, at which time the stock percentage would be brought up to 50 percent all at once.
It’s possible to balance the investment you have in the stock market by utilizing constant-ratio formulas, but the practice should be entered into with care so as not to unduly upset your portfolio.
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