MF Portfolio For You Cash Debt Equity

You invest for a purpose. The best way to go about doing investments is by following a portfolio approach with a clearly defined asset allocation. DSIJ helps you to navigate through the many variables required to build an ideal portfolio.



There are situations when the whole is greater than the sum of parts. Our investment is one such situation where the individual investments are likely to underperform your overall portfolio in terms of risk and return. Many of us believe investment in mutual fund is all about identifying the right funds that have outperformed their respeictive peers and categories on all the major counts. The fund has been consistent in its performance and has risk level below its peers. The fund is being managed by a great team and, finally, the expense ratio of the fund is also comparatively lower.

Despite all these factors which favour a fund selection, it may not be suitable as part of your portfolio. The reason being the fund may not be helping your portfolio to earn extra return or reduce the overall risk. Therefore, you need a better understanding of how a fund is investing and whether its strategy is compatible with your goals and portfolio.

Finding ideas for your portfolio
The normal practice that most of us follow while investing is we first invest and then assign some goal for which we will use this investment. However, experts recommend proceeding the other way round. The first step towards building a portfolio is to identify the goal for which you need to build a portfolio. Otherwise, it is like trying to build a house without a blueprint. You may be able to build a house even without a blueprint; however, it will be more like a collection of rooms instead of a house.

In investing parlance, blueprint refers to asset allocation plan, which means your target mix of stocks, bonds and cash. This will help you to achieve your goals. Proper asset allocation helps you to take rational investment decision, rather than being swayed by short term market movement. For example, between 2014 and 2017, equity gave far superior returns than any other asset class, which led many investors to increase their exposure to equity. Nevertheless, volatility in the performance of the equity investment in last one and half year has taught the lesson of asset allocation.

Every asset class has its own risk-return profile and a particular way of behaviour. For example, stocks give better returns in the long run as compared to bonds and cash, however, the stocks are inherently riskier than the bonds and cash. Hence, if you have a goal that needs to be achieved within few years, say, in three years, debt funds are better suited. However, if you have a goal that is maturing in more than five years or so, equity may be the right place to be in.

To highlight this point, we studied three different funds under three different categories, representing, ‘equity’, ‘debt’ and ‘cash’. Equity is represented by a multi-cap fund, debt is represented by a long duration bond fund and cash is represented by a liquid fund.

The following figure represents the character of these three asset classes:



The above figure clearly shows how equity is a clear outperformer in the long run. However, in the short run, equity is more volatile and is likely to generate negative return. The third part of the figure shows that ‘drawdown’, which measures the decline from a historical peak in that asset class, is highest in case of equity, while for liquid funds, it is the least. A debt fund also goes down, but not in the same proportion as equity funds. Liquid fund remains stable.



The monthly return density plot below shows how monthly returns have been for the funds in last 13 years. Liquid funds have never generated negative returns in our study period while for equity and debt there are fat tails, which means some extreme returns.



Apart from the idiosyncratic character of assets, what also needs to be understood is that these assets play a different role at different stages of your life. Therefore, a person in his or her early 20s who is investing for his retirement or any other long term goal may invest 80-90 per cent of his corpus in equity or equity-dedicated funds. A middle-aged investor cannot be adventurous and should take a more conservative stance if he is saving for retirement. A mix of 60% equity and 40% bonds would be a reasonable choice for a 40-50-year-old with a fair amount of risk tolerance. Finally, a person who is retired and living his golden years should be more conservative in his approach and should be preserving the wealth he has built and, therefore, not more than 20% should go to the equity funds.

The facts elucidated in the previous paragraph were just for reference purpose and are broader in nature. Nonetheless, when it comes to arriving at an asset allocation plan that is specifically geared toward you and your specific goals, the number of variables that need to be explored increases, including how long time period you have for you to start paying for the goal, your current savings rate, and estimated returns for each asset class, the surety with which you want your goal to be achieved, etc.

Consider Your Goals and Time Horizon
The first step in building a portfolio is deciding your goals for which you want to invest. The goals can be for the short term, such as going for vacation next year, or medium term, like replacing your car in the next four years, or long term, such as retirement planning. It is always better to construct individual portfolio with unique mix of equity, debt and cash to achieve any particular goal. This helps you to monitor your portfolio and take any corrective actions, if required, at the goal level itself.

The other way to construct your portfolio is to have goals with similar time frames—for example, if you are looking to buy a second car and also plan to make down payment of your new house around the same time, you could build a portfolio that is geared toward that particular time horizon, which would address both goals simultaneously.



The goals you have set up above will help you to determine the investment amount, horizon and type of asset class. There are some goals that can be easily quantified, for example, the down payment for your next car. Nevertheless, some of the goals cannot be easily quantified. The case in point is your retirement planning. For some, the post-retirement expenses may reduce, while for others, the expenses may increase due to some expensive hobbies they might pursue post-requirement. Once the goal is set and quantified, you may need to apply proper inflation rate to arrive at your goal amount. For different goals, inflation rate will be different. There may be a case that food inflation may be lower as compared to education inflation. Hence, it is important to apply appropriate inflation rate.

Expected Rate of Returns
After you have zeroed down your goals and bucketed them in different time horizons, you need to quantify the amount you will need for each goal. The next step for arriving at target asset allocation is to ascertain the expected returns of the different asset classes. Although it is next to impossible to project the expected returns with a high degree of precision, one can always make an intelligent guess based on the past performance. Nevertheless, the best practice is to be conservative in approach. So, if historically equity has given return of say 12%, it will be prudent to take 10% as the rate of return. Similarly, with the bond too you have to tone down the return expectation.

To get a better understanding of the returns that can be generated by the different asset classes during different time frames, we calculated the annualised returns for three different periods, that is, one-year, five-year and ten-year.

(See table : the return expectation and variation of different asset classes over different time periods.)

Saving Rates
The return on investments is beyond your control and you can only hope the returns are along the expected lines. However, what is in your control is your savings rate. You can always cut some of your unnecessary expenditure to increase your savings and investment. If you want to achieve your financial goals early, the best you can do is to save more, say, a minimum of 20 per cent of your earnings. There is no substitute to parsimony. Saving more or reducing your spending is financially more efficient than earning more money. This is because for every additional rupee of earnings you want to save, you need to earn Rs. 1.3 due to taxes you pay on your earnings.

The Amount to Invest
Now that you have decided on all the important variables such as your goals, investment horizon, savings rate and historical returns your investment is going to make, the next step is to arrive at an appropriate asset allocation for each goal and time horizon. Now, plugging in these numbers in your Excel sheet, you can get the desired asset allocation.

Building your portfolio
Now you have everything at your disposable to build your portfolio. You should start with selecting your core funds. These funds might not be star funds that have outperformed their peers and benchmarks with a wide margin. But these are also not the funds that are terrible and have not delivered in terms of returns. These are the funds that are reliable year in and year out and you want to hang on with these funds for the long run, even if these funds are not giving you the expected returns. These are the funds that are well-diversified across sectors and individual stocks and mostly invest in large-cap stocks. These funds perform better than others, especially when the markets hit a rough patch. We saw this in the last one-and-half years when the large-cap funds outperformed all other equity-dedicated funds. You should be holding anywhere between 50-75% of your equity holdings in core funds. For your bond holdings, the core should be long duration bond funds that invest in government securities.

"Investing for short terms goals can be tough. This is because you may be motivated to invest too much in stocks as equity market is going good. Thereby, you will be risking a major fall in the value of your investment whenever you need it. On the other extreme, you play it too safe, sticking with ultra-safe bank fixed deposits and money market funds that offer limited upside potential."

The balance 25-50% of your investments can be invested in non-core funds, which are not as diversified as the core funds and invest in specific part of the market. For example, small-cap funds or sectoral funds or thematic funds can form part of your non-core holdings. These non-core investments can see more churning than your core funds.

There are various ideas which will help you build your portfolio. One of the most common ones is based on your risk profile. Other common ways are based on your financial goals and the tenure for which you want to invest for a goal. In the following examples, we will take portfolio for different time frames as a basis to build portfolio. We have applied different quantitative techniques to arrive at the following asset allocation plan. For example, to build a portfolio for the short term goals, we have optimised the portfolio with the objective of minimising the risk, which we have taken as the standard deviation of the portfolio. In case of intermediate term goals, we have used risk-return trade-off as optimising function, whereas in the case of long term goals, we have used return maximisation as a criterion to arrive at asset allocation.

Building Portfolio for Short Term Goals
Investing for short terms goals can be tough. This is because you may be motivated to invest too much in stocks as equity market is going good. Thereby, you will be risking a major fall in the value of your investment whenever you need it. On the other extreme, you play it too safe, sticking with ultra-safe bank fixed deposits and money market funds that offer limited upside potential. Therefore, you have to strike the right balance between risk and return to minimise your risk and optimise your return. The major goals that can be set for such investment are a foreign vacation or down payment for your car loan or home loan. These goals are normally within 5 years from the present.

Based on the past mean returns of different asset classes and assuming different risk profiles, you can have the following portfolio. The portfolio is made assuming you want to minimise the risk. We have assumed maximum exposure to any asset class at 50%, while the minimum is 10%. In the equity portfolio, you should have exposure to large-cap funds, while for debt funds, you should chose those funds that have duration lesser or equal to your investment horizon. For liquid funds, you can use funds that invest in high quality bonds or government bonds.



"Saving more or reducing your spending is financially more efficient than earning more money. This is because for every additional rupee of earnings you want to save, you need to earn Rs. 1.3 due to taxes you pay on your earnings."



Building Portfolio for Intermediate-Term Goals
These are those goals that are five years away from now, but are less than 10 years. Some of the most important intermediate term goals are children's higher education or their marriage. Because intermediate term investors want to see their money grow, but do not wish to have to deal with extreme volatility, they should put at least 50% of the money in a safety net of a bond fund or liquid fund and the remaining 50% in equity funds. Mid-cap and large & mid cap funds make the most sense for the core-stock portion of an intermediate term investor’s portfolio. They can also take part exposure in small-cap funds as non-core holdings to spice up the returns. For a core fixed-income holding, invest in a medium term bond fund. When you are within three years of your goal, you should shift your equity funds to the short-term debt funds, which will help you to keep your accumulated wealth intact. You need to preserve what you have made, rather than running the risk of having to draw on your portfolio when it is down.

Since for intermediate terms goals you can have 50 per cent in equity and remaining 50% in debt, you can have the following portfolio where all the assets can have similar allocation.

Building Portfolio for Long-Term Goals
If your goal is 10 years away or more, such as retirement or second home, you can afford to take more risk with your portfolio. Because your ultimate aim is to make sure that your nest egg grows, keep 80 per cent or more of your assets in equity funds. In earlier paragraphs, we have analysed the return behaviour of different asset classes and have seen that equity funds offer better appreciation potential than the bond and liquid funds. And because risk control is much less of a consideration with a long-term portfolio than it is with a short-term or intermediate-term portfolio, you can also afford to dedicate a bigger share of your equity portfolio to small-cap funds that are risky in the shorter term, but offer potentially higher returns in the long run. You can also take exposure to thematic funds as non-core holdings depending upon your risk appetite. For the core-bond component of a long-term portfolio, a long duration bond fund fits the bill.

Following is the asset allocation plan for investors having long term goals.



Conclusion
Once you know your asset allocation plan, the next question that comes to the mind of an investor is the number of funds to hold. Taking into consideration the above asset allocation plan, there is no need to go beyond 10 funds. The ideal number of funds should be seven, but the maximum can go up to 10. This is because if you go beyond 10, there is hardly any benefit of any diversification as the standard deviation of your portfolio hardly improves. While building your portfolio, you should also check that the funds you choose have very few overlapping holdings.

We strongly believe that the portfolio should be built based on your asset allocation plan which, in turn, is determined by your goals, their duration and your risk appetite. You can have a goal in your mind and have a core and non-core portfolio to achieve that.

Building a portfolio is the starting point of your journey towards achieving your goal. The next logical step is to keep a track of your investment, review it and rebalance it at periodic intervals. We believe the above model MF portfolios will help you to plan your investments in a better way.