The Constant Ratio Formula, Making History

by David Jenyns on November 16, 2007

The constant ratio formula is not a new formula. The first widely publicized use of the constant-ratio formula n the late 1930s was the “Yale Plan,” so-called because Yale University managed a part of its endowment fund according to the formula. The fund was started with stocks at 30 percent.

If the stocks held advanced to a point where their total value amounted to 40 percent of the total fund, they were cut back to 35 percent. If an advance in stocks again brought the figure up to 40 percent, stocks were to be cut back again to 35 percent. If the market declined at the beginning of the plan or otherwise to as low as 15 percent, they were to be brought up to 20 percent.

The plan was subsequently revised at various times to allow for more fluctuations in stock prices, but the principle remained essentially the same, and resembled somewhat the modified plan discussed above, where ratios are adjusted in order to take advantage of trends continuing in the same direction over a long period of time. Yale apparently had fairly satisfactory results with the plan, but has in recent years changed it to such an extent that the University can now be said to have all but abandoned the formula method.

Kenyon College, however, also an early user of formulas, is still using the original plan, but the one it uses has never been, strictly speaking, a formula at all, since its investment committee has always felt free to depart from the plan whenever such a course seemed advisable. The ratio used is 40 percent in stocks, the remainder in bonds, and the plan is not to buy any stocks when the percentage is above 40, or to sell any when the percentage is below 40. When or whether to adjust the portfolio is up to the committee. Investment results have been highly satisfactory since the formula was first adopted about 20 years ago.

Undoubtedly the widest use of the constant-ratio plan is in large investment portfolios managed by trust departments of commercial banks and investment counselors. Many such investment professionals specify when a management contract is agreed to that the account will contain certain percentages of stocks and bonds, the exact figures depending on the needs of the client. In some cases, adjustments are not made by buying or selling securities already in the portfolio, but only in the disposition of new money which is added from time to time. The obvious advantage of this method under such circumstances is that both the portfolio manager and the client have a clear understanding of the principles according to which the portfolio is to be managed, which can help prevent disputes from arising. This, of course, is in addition to the investment advantages of the technique.

The fact that so many institutions have used the constant-ratio formula even on an informal basis is evidence of the valuable guidance that this investment technique can give.

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