Building A Winning Portfolio

Financial independence, though desired by many, is achieved by very few. Making a winning and sustainable portfolio will help you to achieve it. There is no secret mantra or rocket science to attain your financial independence early and securely. The formula is well researched, documented and open to all. The only problem is, however, it is followed by very few. It requires a well-planned strategy and a disciplined approach. Garry Kasparov, a Russian chess grandmaster, famously said, "If you change your strategy frequently, you don't really have one." Hence, you need to stick to the strategy to attain your financial goals. This story will illustrate the assets you need to invest in, the ideal proportion of assets and how the proportion should change with times. 

Before going into the details, it is important to know the various components that form the basic building blocks of your portfolio. If you are a mutual fund investor, there are various products available for you to choose from, primary among them being equity and debt. Although direct investment in these underlyings might help you, however, investment through mutual funds is recommended as it requires lesser supervision and time on your part. Maybe we are biased and believe that investing via mutual funds is the best route for most of the investors in most of the situations. Before we embark on the journey of making a sustainable portfolio, we need to know about these two primary investment avenues available to us. 

Equity Funds 

This is probably the most known category of mutual funds among retail investors. These funds are categorised on various parameters. For example, in terms of size, these are categorised as small-cap, mid-cap and large-cap funds, and in terms of sectors, some of the categories include healthcare, information technology, banking, real estate, etc. There are also funds that invest in equities of other countries known as international funds. 

According to SEBI’s rule, there are 10 types of equity schemes. Depending upon the category, these funds invest in a given set of stocks. For example, a large-cap fund needs to invest a minimum of 80% of its total assets in equity and equity-related instruments of large-cap companies. Every category has its own risk-return profile, which helps investors to select the right category of equity funds that suits their own risk-return profiles. 

Debt Funds 

This is probably lesser explored instrument by retail investors. Mutual funds that invests in fixed income securities are known as debt funds. Every individual debt is issued with a fixed maturity date, that is, the date when investors are repaid the principal amount of the bond. A typical debt fund, depending upon its category, keeps on buying new funds to replace the bonds that are maturing. Therefore, at any given point of time, a debt fund might be holding some long-term bonds, some intermediate-term bonds and some short-term bonds that are nearing maturity. The weighted average term to maturity of the cash flows from these funds also called duration determines their category. For example, for a short duration fund, the weighted average term should be between one year and 3 years. Similarly, for a long duration fund, it should be greater than 7 years. The importance of the maturity period is that it is used as a measure by bond fund investors to determine if a particular bond is appropriate for them, considering their time horizon and risk tolerance levels. The higher the duration of maturity, the more sensitive the fund would be to changes in the interest rate. Taking an example of fund with duration of 4 years, a bond fund investor should expect a decline in their investment value by 4 per cent for every single percentage increase in the interest rate. Similarly, its value increases by the same percentage in case the rate declines. 

Why To Invest In Bond Funds 

Having understood the bond funds, you might question why should you be investing in them? The reason is that bond and bond funds have a low correlation to stocks or equity funds and hence they act as a stabilising force for your portfolio. For example, during 2008, when equity funds were down by anywhere between 35 per cent to 75 per cent, depending upon the categories, bond funds during the same period on an average gave positive return and the best medium-term debt funds generated return of more than 20 per cent 

The below diagram clearly shows why you need to invest in debt funds. The table summarises what would have been your returns (%) in year 2008, had you invested in equity and debt both in different proportion. Although, an event like 2008 is rare, the only problem is that such events do not come with warning and can pop out from nowhere and catch you off guard. Hence, a portion of your fund should always be invested in bond funds It is easier said than done to invest in bond funds, as there are more varieties in bond funds than equity funds. The simple rule is to select a bond fund having duration (explained earlier) that matches your investment time horizon. For example, if you need money in the next three years, then you can invest in short duration bonds that have duration of 1-3 years. You should avoid investing in bond funds that have a duration longer than your investment time horizon. Also, do not try to time your purchase/sale with interest rate hike/cut. Keep your investments in bond funds simple. 

The next obvious question that may come to your mind is how much of your total portfolio should go into bond funds. Although, a popular rule of thumb is to own your age in bond funds. This means that if you are 30-year-old, you should invest 30% in bond funds and 70% in equity funds. Nevertheless, this approach will not give you optimum results and you should consider factors such as your financial background, financial goals, risk tolerance and returns expectations to arrive at amount you need to allocate to bond funds. 

Asset Allocation: The Cornerstone Of Successful Investing 

The most fundamental decision you will ever make in investing is the allocation of your assets. How much should you own in stock, bonds and cash. Some of you might be thinking there are other investment avenues too like commodity, bullion, etc. Nonetheless, research shows that investments in stocks, bonds, and cash have proven to be a successful combination of securities for portfolio construction and is a primary determinant of your portfolio returns. 

Some of the research shows more than 90% of the portfolio return is determined by allocating right amount of funds in these asset classes. In the year 2003, the Vanguard Group did a study using 40 years of data of 420 balanced mutual funds which invests in both equity and debt. It found that 77 per cent of the variability in return was determined by the asset allocation policy of the fund rather than selection of individual securities. 

How To Design Your Wining Portfolio 

'One size does not fit all' so goes the adage, which is aptly applicable in the case of designing a portfolio. Therefore, before you build your portfolio, there are few basic questions you need to answer. First, you should know your goals, whether it is to finance your home, child’s education or a vacation at one of the exotic locations abroad. The second question that need to be answered is about your investment horizon. 

Depending upon the horizon, a right mix of assets is determined. Stocks are usually unsuitable for short time frames. Besides, you should know your risk tolerance as it imposes a discipline in your investment and helps you resist performance chasing. 

Equity Portfolio 

To get the maximum benefit of diversification, the stock allocation should be further divided between various subcategories. This is because different type of stocks performs differently at different points of time. Therefore, it is advisable to have as many different types of stocks as is reasonable practical. For example, the mid-cap and small-cap stocks, and hence the funds dedicated to these categories, are down by 10-15% in the last six months. In the year 2017, these stocks were the darlings of the investors and some of the funds were even up by 50%. Besides, cap-wise category, international stocks are also another option that helps you to diversify your equity portfolio. In the last one year, the international funds have generated return of 12 per cent. This return is better than many other categories. 

Bond Portfolio 

The bond part of your portfolio should remain simple. A single low-cost short or intermediate-term good quality fund should be adequate in most of the cases. The only thing that you should take care of is the duration of the bond should not be greater than your expected investment time frame to meet your goal. If the duration of your bond fund is lower than your investment horizon, it reduces the chance of a negative return. 

Finally, Your Portfolio 

It is not only difficult, but also impossible to recommend a specific portfolio that suits everyone, as each investor is unique and has unique needs and requirements. They may be different in terms of their goals, time frames, risk tolerance and their financial background. Nevertheless, the following portfolio may act as a guide to make a winning portfolio for you. You may tweak it little bit here and there to make a portfolio that suits you. It is assumed that you have emergency cash savings to the tune of 3-12 months of income 

Track your progress and rebalance whenever necessary 

Making a portfolio is your first step towards achieving your financial goal. The next step is to keep track of your progress and keep on rebalancing whenever necessary. Rebalancing is simply the act of bringing your portfolio back to your target asset allocation after it has drifted from the required or desired level due to various factors including change in your financial goal or age. For example, you are in 20s and 45% of your portfolio comprises of equity diversified funds, but after a year, equity prices have surged, and your equity portion reaches 55% of your portfolio, so you need to sell 10% of equity portion to bring back to the desired asset allocation. Rebalancing forces you to follow the classical investment rule, that is, 'sell high and buy low'. You sell your outperforming assets and buy underperforming assets. This helps you to improve your portfolio returns as returns from any asset class tends to revert to the mean over time. This means outperforming assets may underperform going forward, and vice-versa. There are various methods of rebalancing your portfolio, which you can chose based on their suitability to you. There are only two considerations you need to consider while rebalancing. The first is cost and the second is tax. You need to check the impact of these two to make your re-balancing fruitful. 

Making a winning portfolio is incredibly simple if you follow the above rules. Create a diversified portfolio based on your goals and age. Keep track of your investments and rebalance them whenever necessary to stay on course. A simple thumb rule of your portfolio is it should pass ‘sleep test’. If you sleep soundly without worrying too much about your investment, you have struck the right cord. There is no investment worth worrying about and losing sleep over. The volatility in the market is its inherent nature—it should not worry you too much, but you should live with it comfortably