Great mantras to unlock stock market riches

"Buy when there is blood on the street," advised the legendary investor, Baron Rothschild.
But how does one summon the courage to buy when everyone around is selling? The solution lies in first arriving at your right investment mix between wealth-growing but volatile investment avenues, such as shares, and wealth-protecting ones such as bonds or bank deposits.
With that in place, formula plans can unlock the door to stock market riches -- by helping you, automatically, buying low and selling high.
Formula plans are a type of investment strategy that makes use of pre-determined rules for the nature and timing of change in one's portfolio as the market rises or falls.
Such rules ignore prevalent market moods of optimism or pessimism and help you automatically reallocate funds from one asset class to another with changing circumstances, thus helping you automatically buy low and sell high.
How formula plans work
A typical formula plan primarily consists of two portfolios, namely an aggressive portfolio and a conservative, or defensive, portfolio. The former consists of securities that are more volatile as compared to the latter.
Thus, the conservative portfolio often comprises bonds meant to provide stability to the entire portfolio. Normally, the greater the difference in the volatility of the two portfolios, the higher is the expected return.
In order to attain the maximum volatility spread, it is preferable to have bonds of the highest security ratings in the conservative portfolio. In essence, it is the negative correlation between the two portfolios that leads to gain from formula plans.
As noted, formula plans are based on pre-determined rules for timing the re-allocation of money from one portfolio to the other. This leads to an automatic sale of an asset class when its prices rise, and its purchase when the prices fall.
Accordingly, such strategies achieve the maximum gain when the two portfolios are moving in opposite directions.
One of the major concerns of a formula plan is that prices of stocks and bonds don't always move in opposite directions. When the prices of these two distinct asset classes move in the same direction, it spells bad news for the plan.
In order to overcome this problem, some experts suggest that the entire conservative portfolio should comprise only cash and bank savings account, or money market mutual funds all of which have near-zero volatility, thus providing the maximum volatility spread between the portfolios.
On the other hand, the aggressive stock portfolio needs to provide the highest possible volatility.
Let us now consider some of the commonly used formula plans.
Constant rupee value plan
In a constant rupee value plan, the rupee value of the aggressive portfolio is held constant. Whenever the value of the aggressive portfolio rises, a part of it is sold to bring it back to its original (target) value, and the funds generated are re-invested in the conservative portfolio. The converse action is called for in case the value of the aggressive portfolio falls.
The primary advantage of this formula plan is its simplicity. The investor clearly knows the total amount he needs to keep invested in the aggressive equity portfolio at all times.
The constant rupee value plan requires setting up action points, also referred to as revaluation points. These are the points at which the investor makes changes in his two portfolios based on any changes in their respective values.
These actions points can be in terms of periodicity, change in some economic or market indicators, or even in terms of percentages. In order to make the plan more effective, it is important to estimate the possibility, and extent, of fluctuations in the aggressive portfolio's value.
This is because the value of the conservative portfolio should be sufficient to provide funds for re-allocation in the aggressive portfolio should there be a steep fall in its value.
Suppose an investor wants to invest Rs 10 lakh (Rs 1 million) using the constant rupee value plan. He decides that the value of the aggressive portfolio should be Rs 5 lakh (Rs 500,000) and that the remaining Rs 5 lakh would be invested in a conservative portfolio comprising bonds.
Accordingly, he purchases 25,000 shares of a company currently trading at Rs 20 for the aggressive portfolio. He wants to rebalance the portfolio each time the value of the aggressive portfolio moves up or down by 20 per cent.
Rebalancing will be done in such a way that the amount invested in the aggressive portfolio is equal to Rs 5 lakh after each rebalancing. Table 1 shows how the mechanism operates for both upward and downward changes that call for rebalancing the portfolio.