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Building a great portfolio of mutual funds is both easy and simple, provided you follow this step-by-step method
What is a portfolio?
In a general sense, all investments held by an investor are collectively a portfolio. But to the thoughtful investor, a portfolio must be something more.
A portfolio is a group of investments that are meant to serve a single goal. Each distinct financial goal must have a distinct portfolio dedicated to it. Why is this so?
Have separate goal-oriented portfolios
You need a distinct portfolio for each goal simply because you will need the money at different points of time, and probably have different risk-reward requirements for each goal. As an illustration, think of a 35-year-old investor who needs to buy a house two years in the future, needs to pay for a child's professional education seven years in the future and save for retirement 25 years in the future.
A two-year horizon means that her risk-tolerance (and therefore equity exposure) should be very low. The seven-year horizon for the child's education could justify a somewhat higher risk but since this expense cannot be postponed at all, the risk cannot be very high. In contrast, the 25-year horizon for the retirement fund means that a high risk can be tolerated, especially since beating the compounded affect of inflation over such a long period will need good returns for a good number of years.
There is simply no way of creating, tracking and managing a single portfolio that could serve multiple goals simultaneously. If this investor has a single lump of money that is treated as a single portfolio, then she has no way of setting and following the correct risk level for each part of the money.
Each goal needs a different amount of money and will need to be liquidated at different times in different ways. It's clear that the only sensible way to invest is to have different portfolios for each financial goal.
Decide on an asset allocation
The next step in building your portfolios is to figure out the way it should be split between different types of investments. This has to be done at two levels. At a higher level, you need to decide how much to invest in equity funds and how much in debt funds. At a more micro level, you need to allocate your money between different kinds of equity and bond funds.
The first thing to understand here is that there is a distinct time band that is suitable for each kind of fund and if you do nothing but just match each of your portfolios' expected life-span with a type of fund, most of your task is done. At the broad level, money that is needed within the next three to five years must be in debt funds while money that is going to be needed after that can mostly be in equity funds. Very long-term money--something that you are absolutely certain will not be needed for more than ten years--should all be in equity funds. Over such long periods of time the risk of investing in equities--or at least that of investing in a good equity fund--is minimal--and the rewards you can expect are high.
The flip side of this purely time-based asset allocation approach is that it implies that long-term money must be actively reallocated when it becomes short-term. When an expenditure item is fifteen years away, you may put its portfolio entirely in equities, but ten years later, when only five years are left before that portfolio has to be encashed, the original all-equity allocation becomes dangerous. At that point, this portfolio is effectively a five-year portfolio and a substantial part should gradually be shifted to debt.
The conventional way of deciding asset allocation that many investment advisors follow is to treat investors' entire investment as a single portfolio and then decide on an asset allocation based largely on the investors' age and perceived risk appetite. This is inappropriate in most cases. The correct asset allocation has a lot more to do with what you intend to do with the money than on your age. For example, take the typical retirement portfolio. Conventional thinking suggests that very little risk can be taken with one's retirement portfolio. An investor with a couple of years to go for retirement is almost always suggested an all-debt portfolio. However, in our way of thinking, this is a mistake. A retirement portfolio isn't something that is going to be spent off in a day. Instead, it is a pool of money that is going to be needed for a long-time, perhaps till the investor turns 90 or so.
This means that not only does a part of the money is actually very long term, the returns on the money must be good enough to counteract the compounding effect of decades of inflation.
If you retire at the age of 60 and put away all your money into a safe debt-based investment that underperforms inflation by just two per cent a year (not impossible in these times of low interest rates), your money will be worth almost 47 per cent less by the time you are 90!
It turns out that 'safe' investment is actually the most dangerous thing you could have done with your hard-earned retirement fund. Thus, a realistic appraisal of your own financial needs is the most important part of deciding on your asset allocation. Once you have done that, the rest is easy.
One temptation one must never fall into is to decide on asset allocation by trying to time the financial markets. If you look at the history of Indian financial markets, you can see distinct periods when either stocks were generating great returns or debt was generating great returns.
It's easy to imagine the wonderful returns that one could have generated by being completely in the right kind of asset at the right time. However, this is 20:20 hindsight. In practice, it is almost impossible to predict things accurately enough to profit from market timing.
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