What Is a Constant Ratio Plan?

A constant ratio plan (also known as "constant mix" or "constant weighting" investing) is a strategic asset allocation strategy, or investment formula, which keeps the aggressive and conservative portions of a portfolio set at a fixed ratio. To maintain the target asset weights – typically, between that of stocks and bonds – the portfolio is periodically rebalanced by selling outperforming assets and buying underperforming ones. Thus, stocks are sold if they rise faster than other investments and bought if they fall in value more than the other investments in the portfolio.

If a portfolio's strategic asset allocation is set to be 60% stocks and 40% bonds, a constant ratio plan will ensure that as markets moves, that 60/40 ratio is preserved over time.

The Basics of a Constant Ratio Plan

A constant ratio plan is an example of a long-term formula investing strategy, that does not involve security analysis and forecasting, or market timing. It is able to leverage active-like management qualities through systematic rebalancing according to a prescribed formula, as the market rises and falls.

When the actual ratio differs from the desired ratio by a predetermined amount, transactions are made to rebalance the portfolio. Constant ratio plans, together with constant dollar value plans, are similar to buy-and-hold asset allocation strategies used in portfolio management, except that buy-and-hold strategies never rebalance. A constant ratio plan would ensure that a 70/30 or 80/20 asset allocation (stocks to bonds) remains 70/30 or 80/20 even as markets move.

The cost of these rebalancing transactions reduces investment returns. But constant ratio plans aim to smooth out investment returns over a longer time horizon by adjusting the portfolio counter-cyclically, and taking profits on speculative stocks that have rallied strongly.

By selling outperforming stocks and buying underperforming ones, constant ratio plans run counter to momentum investing strategies that sell underperforming assets and buy outperforming ones. This is why they work best in volatile markets with a general mean-reverting pattern.

There are no hard-and-fast rules for timing portfolio rebalancing under strategic or constant-weighting asset allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than +/- 5% from its original target.

Smart Beta ETFs and Formula Investing

Because capitalization-weighted indices sometimes overweight overvalued stocks and underweight undervalued ones at the peak of bull markets, some smart beta exchange-traded funds (ETFs) are also counter-cyclical – targeting factors like momentum, volatility, value and size – by systematically overweighting or underweighting them.

Smart beta rebalancing uses additional criteria, such as value defined by performance measures like book value or return on capital, to allocate the holdings across a selection of stocks. This rules-based method of portfolio creation adds a layer of systematic analysis to the investment that simple index investing lacks.