Starting Your Constant-Ratio Plan
Before beginning a constant-ratio plan, there are two decisions the investor must make. First, there is the problem of what ratio to adopt. Many times a 50-50 ratio is used, and in fact the plan is sometimes called the “equalizing” formula, because the stock and bond portions are “equalized” periodically.
But there is no reason to stick to the 50-50 ratio. Some conservative investors prefer a higher percentage of bonds, and the more venturesome choose a higher percentage of stocks. The investor who can afford the risk will still obtain some of the advantages of using the formula method even if he hikes the stock percentage to 75 percent, and will profit more in case the market heads upward. And the investor who decides to use a higher percentage of bonds will get the advantage of equity investments protected to some extent by his use of the formula method while maintaining a higher degree of safety because of the larger bond portion of his account.
Another problem to be met is the question of when to start the plan. As in the case of the constant-dollar method, the level of the market at which the plan is begun is of no small importance. The effect on final results will not be as great as in the constant-dollar method, since the constant-ratio plan is continually adjusting the amount of stocks held as the market shifts.
One study, comparing plans with various starting dates, points up the importance of this.8 A hypothetical fund started in 1935 shows a profit immediately, while an account begun in 1930 shows an immediate loss and takes about 15 years to move into a profit position.
Obviously, the investor can never be sure whether the market level at any particular time will turn out to be high or low, and there is no ready answer to the problem of the starting date. If the investor who wants to use a constant-ratio formula is to be expected to predict the future direction of the market, then the formula method is not as “automatic” as its supporters claim, and if he is capable of making such a prediction, he doesn’t need a formula.
One solution is to combine the constant ratio plan with a dollar averaging approach. Assuming a 50-50 stock-bond ratio has been decided on, 10 percent of the account can be invested in stocks immediately, say, with the account being treated as a 10-90 constant-ratio plan for the first year, after which time the account is adjusted to a 20 percent position in stocks. After another year, the account is adjusted again to a 30-70 proportion, and so on, until it reaches the 50-50 point, in four years.
This would not necessarily mean buying exactly the same dollar amount of stocks each time, since market fluctuations would inevitably change the percentages between adjustment points. Let us assume, for example, the investor starts with a $10,000 fund, and buys $1,000 of stocks and $9,000 of bonds. After a year, when he is ready to re-adjust, the market has gone up 10 percent, bringing the value of his stockholdings to $1,100, which makes his total account $10,100. He now adjusts to a 20 percent stock position, or $2,020 of stocks. Since he already holds $1,100 of stocks, he buys $920 more, leaving the bond account at $8,080.
The intervals and percentages used above are arbitrary, of course, and can easily be modified by the investor to suit his own preferences. This procedure is a solution—and a workable one—although it does delay putting one’s formula to good use for a time.
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