Formula Investment Plans

Formula investment plans are long-term investment strategies based on a fixed formula of adding dollars to investments that is applied over time and does not involve security analysis or market timing. While easy to implement, their main drawback is that profits will probably be less than that resulting from active analysis and management. There is potentially an infinite number of formula plans, or variations of them, but the most common formula plans are: dollar-cost averaging, constant-dollar investment, constant-ratio investment, and variable-ratio investment.

Dollar-Cost Averaging

Dollar-cost averaging is a passive investment plan that invests a constant dollar amount per unit of time, such as a month, taking advantage of the natural fluctuations of market prices over time. This technique can be used for specific securities or for securities covering a larger swath of the market, such as exchange-traded funds or mutual funds. The main advantage of dollar-cost averaging is that more shares are bought at a lower price when the market is down than at a higher price when the market is up.

Dollar-cost averaging works best with dividend reinvestment plans (DRIPs) offered by many blue-chip companies, where the investor can buy company stock directly from the company, free of transaction costs. There are no transaction penalties for buying less than a round lot of shares (100 shares) and can even be purchased in fractional amounts. Furthermore, all the dividends can be reinvested automatically if the investor desires. With DRIPs, all the money is invested in the stock, whereas in buying securities in the market, some of the money must be used to pay transaction costs, which will be higher for odd lots (less than 100 shares); and since only whole shares can be purchased, there will be some money left over, unless the share price happened to be an exact multiple of the constant dollar amount allotted by the investor.

The main disadvantage of DRIPs is the lack of diversification, since almost all DRIPs are offered by blue-chip companies.

Constant-Dollar Plan

The constant-dollar plan, which is also sometimes used synonymously for dollar-cost averaging, is a plan consisting of 2 portions: speculative securities to hopefully earn substantial capital gains, and conservative investments, such as a bonds, Treasuries, or savings to earn interest while protecting the principal. A constant-dollar range that is delimited by triggers is applied to the speculative portion of the portfolio, so that if the speculative portion falls outside of the range, the portfolio is rebalanced to bring the speculative portion back to its original amount. If the speculative portion rises above a certain dollar amount, enough of the speculative portion is sold to bring it back to the original dollar amount, with the proceeds of the sale transferred to the conservative portion of the portfolio. If the speculative portion falls below the range, then money is taken out of the conservative portion to buy more speculative securities.

Constant-Ratio Plan

The constant-ratio plan is similar to the constant-dollar plan in that they both consist of a speculative portion for greater capital gains and a conservative portion for lesser risk, but the constant-ratio plan maintains a specific ratio of speculative to conservative securities. When the proportion deviates by a certain percentage, then securities are sold out of the larger portion to buy more securities in the smaller portion, thereby maintaining the desired ratio.

Variable-Ratio Plan

The variable-ratio plan uses a variable proportion of the risky investments to the safer investments, such that when the prices of the risky securities are low, more money is invested in them, but when they are high, they are sold with the proceeds placed in conservative investments. This obviously involves some market timing, but it takes advantage of the cycles of low and high values that risky assets continually pass through. This is particularly true of futures and commodities, because if their prices veer too low or too high, economic forces, primarily changes in the supply and demand, will come into play that will restrain their prices from becoming too extreme.

In a simple variation of this plan, when the value of the speculative portion of the portfolio reaches a certain percentage, enough speculative securities are sold to reduce the speculative portion down to a lower percentage of the portfolio. For instance, if the speculative portion reaches 70% of the total portfolio value, then enough speculative securities may be sold to bring the speculative portion down to 30%, with the proceeds of the sale going to conservative investments. When the prices of the speculative securities drop, then more money is invested in the speculative securities to take advantage of the lower prices, and, hopefully, ride the cycle up to higher prices.


How successful any of these plans are in actuality will depend on the specific details of the plans and the investment horizon. However, they are more likely to be successful the longer the investment horizon, especially if a large part of the portfolio is invested in risky assets.