Portfolio Revision Meaning, Objectives, Need, Constraints

Meaning of Portfolio Revision

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 as important as portfolio analysis and selection.

Portfolio revision involves the adjustment or combination of securities held within an investment portfolio. Portfolio revision may be achieved either by replacing existing securities within the portfolio with different ones or by adjusting the allocation or proportion of funds invested in each security within the portfolio.

New securities may be added while existing securities may be removed from the portfolio based on factors such as thorough analysis, fundamental research, market evaluation, and consideration of the investor’s overall investment strategy and risk tolerance.

Portfolio revision thus leads to the buying and selling of securities based on factors such as the investor’s strategic objectives, risk tolerance, market outlook, and the specific characteristics of individual securities. The objective of portfolio revision is similar to that of portfolio selection, to maximize the return while minimizing risk to align with the investor’s financial goals and risk tolerance.

Portfolio revision enables investors to take advantage of new opportunities and adjust to changing circumstances. It ensures that the portfolio remains aligned with their long-term objectives.

Objectives of Portfolio Revision

The objective of portfolio revision is the same as the objective of portfolio selection, i.e., maximizing the returns for a given level of risk or minimizing the risk for a given level of return. The objectives of portfolio revision are given as follows:

  1. To maximize the returns, and
  2. To minimize the risk

Need for Portfolio Revision

One of the main reasons for the need to revise a portfolio is changes in the financial markets since the creation of the portfolio. The need for portfolio revision may arise because of Market Volatility, Sector Rotation, Asset Valuations, Interest Rate Changes, and Global Events. Some investor-related factors affecting portfolio revision include life events, risk tolerance, financial goals, and liquidity needs.

Other factors may be listed as: 

  1. Availability of additional funds for investment.
  2. Change in risk tolerance.
  3. Change in the investment goals.
  4. Need to liquidate a part of the portfolio to provide funds for some alternative use.

The portfolio requires revision and adjustment to align with the investment strategy and changes in the investor’s position, evolving needs, goals, and risk tolerance. Thus, the need for portfolio revision may arise from changes in the financial market or changes in the investor’s position, namely his financial status and preferences.

Constraints in Portfolio Revision

Portfolio revision or adjustment necessitates the purchase and sale of securities. The practice of portfolio adjustment involving the purchase and sale of securities gives rise to certain problems which act as constraints in portfolio revision. Some of these are as follows:

1) Taxes

Tax is payable on the capital gains arising from the sale of securities. In many tax systems, long-term capital gains are usually taxed lower than short-term capital gains. To qualify as long-term capital gain, an investor must hold a security for not less than 12 months before sale. Frequent sales of securities during periodic portfolio revision or adjustment 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.

2) Transaction Cost

Buying and selling securities involve transaction costs such as commission and brokerage. Frequent trading (buying or selling) of securities to adjust a portfolio may increase transaction costs thereby reducing the gains that might be achieved from such revisions. Hence, the transaction costs may affect the timely revision of the portfolio ultimately missing out on beneficial adjustments. 

3) Intrinsic Difficulty

Portfolio revision is a difficult and time-consuming process. The methodology to be followed for portfolio revision has not been clearly defined. Different approaches may be considered for this purpose based on investment objectives, risk tolerance, time horizon, and market outlook. The challenges associated with conducting portfolio revision may act as a constraint to portfolio revision.

4) Statutory Stipulations

Investment companies and mutual funds generally manage large portfolios in many countries. These companies provide professional management advice to investors. It plays an important role in the financial market by providing a diversified range of assets, Regulatory Oversight, Product Innovation and economies of scale to help investors pursue their financial goals. These institutional investors are normally governed by certain statutory regulations that govern their investment activities. These stipulations often act as limitations while making timely revisions to the portfolio.

Portfolio Revision Strategies

There are two different strategies used for portfolio revisions, as given below:

1) Passive Revision Strategy

The passive revision strategy, in contrast, involves only minor and infrequent adjustments to the portfolio over time. The practitioners of passive revision strategy place their trust in market efficiency and homogeneity of expectation among investors. Many investors lack the motivation to actively trade and revise portfolios periodically. The passive revision strategy involves making adjustments to the portfolio is carried out according to certain predetermined rules and procedures known as formula plans. These formula plans help the investor in adapting their portfolios according to changes in the securities market.

2) Active Revision Strategy

Active revision strategy involves frequent and sometimes substantial adjustments to the portfolio. Active portfolio revision involves conducting a thorough analysis and selection of investments within a portfolio. It is based on an analysis of the fundamental factors affecting the economy, industry and company as also the technical factors like demand and supply. As a result, the combination of time, skill and resources required to execute an effective revision strategy will be much higher. The frequency of trading is likely to be much higher when employing an active revision strategy, leading to higher transaction costs.

Formula Plan

Formula plans operate under the assumption that portfolios differ in their characteristics and can effectively reduce individual security risks through a combination of negatively correlated securities. Portfolios usually have a composition of “less risk-less return” securities as well as “high risk-high return” securities. The less risk-less 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 constructed with shares of companies while the conservative component holds mostly fixed-return securities such as debt and treasury bonds.

Portfolio revision changes the individual security selection and considers the total amount invested in either a conservative or aggressive component. This subdivision is often made depending on the objectives of the portfolio. A portfolio with a growth objective would have a major aggressive component. On the other hand, a portfolio that includes regular, guaranteed income would have a major subdivision of conservative investment.

The formula plan helps in the allocation of funds among various types of portfolio components. Since the aggressive and conservative components are expected to behave inversely at any specific point in time.

Assumptions of Formula Plan

The formula plan operates on the following assumptions:

1) An upward trend in the market may result in a decline of stocks in the portfolio or the proportion of stocks may remain constant. In a declining market, the portfolio will be more aggressive and in an upward market, the portfolio will be defensive.

2) Investors generally allocate their funds among common stocks and fixed-income securities in such proportion as per the prevailing market condition, say 30 per cent in common stock and 70 per cent in bonds or vice versa. They may also change this proportion as the market condition changes. In a balanced fund, the investors may maintain a proportion of 50 per cent in common stock and 50 per cent in fixed-income securities.

3) The investors continue to strictly follow the formula plan once adopted and never change it.

4) The stocks are bought and sold whenever there is a significant change in the prices in the market. Such changes in the prices of stocks can be measured with the help of stock indices, such as the Bombay Stock Exchange (BSE), SENSEX (Sensitive Index), or Standard & Poor’s CRISIL, NSE Index (S&P CNX Nifty) strictly follow the formula. ls plan once adopted and never change it.

5) Investors choose stocks which move along with the market reflecting the market’s risk and return. The prices of the selected stocks are closely correlated with the overall market movement. The beta of these stocks will be around 1.0. These stocks belong to fundamentally strong companies.

Advantages of the Formula Plan

A formula plan has the following advantages

1) This plan has rigid rules and regulations to overcome human emotions

2) It provides the basic rules and regulations for buying and selling of securities

4) The plan suggests a course of action designed to achieve the objectives established by the investor.

3) It is highly helpful in determining the optimal timing for investments.

4) It controls the trading (buying and selling) of securities by the investor.

5) The plan enables an investor to earn higher returns.

Disadvantages of the Formula Plan

The disadvantages of the formula plan are as follows:

1) No adjustment is possible due to the inflexible and rigid nature of the rules.

2) Formula plan does not help the investors in market forecasting, which has to be done separately and based on technical or fundamental analyses.

3) The transaction cost will be high for short-term transactions; hence, the plan can be adopted only for long-term investments.

4) The plan does not provide help for the selection of securities which has to be done based on technical or fundamental analyses.

Types of Formula Plan

Portfolio revision involves analyzing and adjusting the structure and composition of shares in the portfolio. It might involve a simple revision of the weights of the shares or the inclusion or dropping of a share to/from the portfolio Portfolio revision can be studied under the following formula plans:

Types of Formula Plan are listed below:

  1. Constant Rupee Value Plan
  2. Constant Ratio Plan
  3. Rupee Cost Averaging Plan
  4. Variable Ratio Plan
Constant Rupee Value Plan

The objective of the constant rupee plan is to achieve a balanced allocation between the conservative and aggressive components of a portfolio with a focus on reaching the target value. The target value could be fixed initially by the investor at a preferred ratio.

For example, a constant rupee plan could consider the initial value of ₹10,000 each between conservative and aggressive portfolios. There can also be an initial value of ₹15,000 and 5,000 in the aggressive and conservative portfolio components respectively. Subsequently, changes in the portfolio components may lead to a reallocation or shift of funds from one component to the other.

The target portfolio value in the aggressive component may be set at the initial value with the excess being transferred to the conservative portfolio. Similarly, any shortfall in the aggressive component can be rectified by using the funds from the conservative portfolio. The purpose of the constant rupee plan is to ensure that the total value of the aggressive portfolio remains stable over time. To achieve this, the investor can monitor the changes in the portfolio components and fix the percentage change in price that would require a portfolio revision.

Advantages of Constant Rupee Value Plan

The advantage of a constant ratio plan is the automation with which it forces the manager to counter-adjust his portfolio cyclically. However, this approach does not eliminate the necessity of carefully selecting individual security measures.

Disadvantages of Constant Rupee Value Plan

The limitation of the plan is that the funds are reallocated from the stock portion to the bond portion. Bonds are also a type of capital market instrument and are influenced by market forces. Both bond and share prices may fluctuate at the same time, with the possibility of both rising and falling in tandem. During the downtrend, both prices may experience a decline followed by a subsequent increase.

 Constant Ratio Plan

This investment strategy involves maintaining the portfolio’s composition by asset class at a certain level through periodic adjustments. When the balance is upset, it is periodically restored by moving money from over-performing assets to under performing ones. This system ensures that no single asset class dominates the portfolio. This is one way to maintain a desirable asset allocation.

The constant-ratio plan specifies that the value of the aggressive portfolio to the value of the conservative portfolio will be held constant at the predetermined ratio. This plan automatically forces the investor to sell stocks as their prices rise, to keep the ratio of the value of their aggressive portfolio to the value of the conservative portfolio constant. Likewise, the investor is forced to transfer funds from conservative portfolios to aggressive portfolios as the price of stocks falls.

Advantages of Constant Value Ratio Plan

The advantage of a constant ratio plan is automatism which enables the manager to regularly adjust their portfolio. However,  this cyclical adjustment does not reduce the importance of carefully selecting individual securities.

Disadvantages of Constant Value Ratio Plan

One major limitation of the plan is that the money is reallocated from the stock portion to the bond portion. Bonds are a type of capital market instrument that responds to market pressures. The prices of both the bonds and shares may rise and fall at the same time. In the downtrend, prices may decline and then gain.

Rupee Cost Averaging Plan

Rupee cost averaging is a strategy that relies on the mathematical principle of “averaging out” investment costs over time. Here investors are buyers in the market. Irrespective of fluctuations in prices, the investors intend to purchase the shares as part of their portfolio-building strategy. 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. On the other hand, when the share price rises, the investors purchase the share in smaller quantities. The primary goal is to increase the wealth of the investors rather than securing returns for them. To expand their portfolio, investors may identify a certain percentage for increasing or decreasing their investments.

Advantages of Rupee Cost Averaging Plan

1) It reduces the pressure associated with market timing by eliminating the need for investors to time their stock purchases.

2) Reduces the average cost per share and improves the possibility of gain over a long period.

3) Applicable to both falling and rising markets, although it works best if the stocks are acquired in a declining market.

4) Makes the investors plan the investment program thoroughly on the commitment of funds that has to be done periodically.

Disadvantages of Rupee Cost Averaging Plan

1) The plan does not indicate when to sell. It is only a strategy for buying

2) The averaging advantage does not yield profit if the stock price is in a downward trend

3) It does not eliminate the necessity for selecting the individual stocks that are to be purchased.

4) Extra transaction costs are involved with small and frequent purchases of shares.

5) The plan appears to be more effective when stock prices have cyclical patterns.

6) There is no indication of the appropriate interval between purchases.

Variable Ratio Plan

The variable-ratio plan gives more flexibility to the investors in adjusting their portfolio components. When the share price decreases, the investor may choose to reallocate a major part of their conservative portfolio to the aggressive component. The desired ratio of investment holding between conservative and aggressive components of a portfolio may vary depending on the level of flexibility the investor wishes to incorporate in the portfolio revision decisions. When the share price increases, then the investors may choose to reallocate funds to maintain a stabilized portfolio.

Advantages of Variable Ratio Plan

The investors automatically adjust their portfolio according to the price changes. The investors are not emotionally affected by the market price fluctuations. By using accurate forecasts the variable ratio plan takes more advantage of price fluctuations than a fixed ratio plan.

Disadvantages of Variable Ratio Plan

1) The selection of security has to be done by the investor by analyzing the merits of the stock.

2) The investor has to construct the appropriate zones and trends for alterations of the proportions.

3) If the zones are too small frequent changes have to be done and it would limit portfolio performance

4) The plan does not help in the selection of scrips.

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