Constant Ratio Plan

The constant ratio plan is an asset allocation strategy that establishes fixed percentages for the different types of securities contained in a portfolio. For example, a typical constant ratio plan could be made up of an allocation of 45 percent of portfolio investments in stocks, 45 percent in bonds, and 10 percent invested in money market (cash) securities. The percentages allocated to the different types of investments are determined by the investor's objectives and risk tolerance. Changes in asset allocation percentages can be made to coincide with changes in these objectives as well as changes in the conditions of the markets. A conservative, risk-averse investor who's approaching retirement and needs additional income might use a portfolio allocation of 25 percent stocks, 70 percent bonds, and 5 percent in money market securities. On the other hand, a young investor seeking growth in his or her portfolio may choose an allocation with a greater possible rate of return (along with more exposure to risk), such as 80 percent invested in stocks, 15 percent in bonds, and 5 percent in money market securities.
Once the allocation percentages have been decided, the investor must next determine the trigger points, or percentages, for rebalancing the portfolio. For instance, let's look at the example of a $100,000 portfolio, with 50 percent of its value allocated to stocks and 50 percent in bonds. Over time the values of the different securities will change and the investor will need to rebalance the portfolio (in other words, bring its allocation percentages back to their original levels). If the stocks in the portfolio increase to $60,000 and bonds decrease to $45,000, the ratio is no longer 50 percent for each. Rebalancing can be done after the passage of a certain amount of time – such as quarterly, biannually or annually – or based on percentage limits (10 percent, 20 percent, etc.). Using a 20 percent limit for the stocks in our example portfolio, rebalancing would be due because the stock values increased to $60,000, which is 20 percent above the $50,000 constant amount. Rebalancing would also be performed if the stocks dropped to a value of $40,000 (20 percent below $50,000).
Now, let's assume that the total value of the portfolio has increased to $105,000 with the stock portion accounting for $60,000 of that amount (which is 57 percent). To maintain the 50/50 ratio and proper risk exposure, the stock portion must be decreased. In this instance the investor would need to sell $7500 worth of stocks to reduce their total value to $52,500, which is 50 percent of the total portfolio value of $105,000. The $7500 proceeds would then be added to the bond holdings to bring their total level back up to 50 percent.
As with the constant dollar plan, the long-term expectation is that the stocks of the portfolio will appreciate in value (as stocks historically have). When this occurs, a portion of stocks will be sold to rebalance the portfolio and increase the amounts invested in the more conservative portfolio instruments. However, if stocks in the portfolio decline while bonds increase in value, then bonds will be sold off to provide funds to purchase additional stock.