Ascertaining your individual financial situation and goals is the first task in constructing a portfolio. Important items to consider are age and how much time you have to grow your investments, as well as amount of capital to invest and future income needs.
While constructing a portfolio, asset allocation mix (i.e. the mix of various assets including equity, debt, gold, etc.) is considered as one of the key determinants of the portfolio’s performance, in terms of risk & return. A suitable asset allocation is typically based on one’s investment horizon and risk appetite. Generally, longer the investment horizon and higher the risk appetite, higher would be the allocation to equity. For example, if the investment horizon is 5 years and above, then 50% to 70% of your investment portfolio could be allocated to equity and 30% to 50% to debt
A second factor to consider is your personality and risk tolerance. Are you willing to risk some money for the possibility of greater returns? Everyone would like to reap high returns year after year, but if you can’t sleep at night when your investments take a short-term drop, chances are the high returns from those kinds of assets are not worth the stress.
Say for example, for a 5 – year investment horizon, it would be advisable to select one or two large cap and one small/mid-cap equity fund or diversified equity funds that invest in large, mid and small cap stocks in varying proportions based on the fund manager’s views and future outlook. For the debt allocation, it is advisable to select on or two short-term income funds. Additionally, one can consider investing in an International equity fund, which invests in European or Asian equity markets. International equities provide exposure to different economic drivers (vis-à-vis Indian equities), thereby helping diversify one’s portfolio.
Understanding your current situation, your future needs for capital, and your risk tolerance will determine how your investments should be allocated among different asset classes. The possibility of greater returns comes at the expense of greater risk of losses (a principle known as the risk/return tradeoff) – you don’t want to eliminate risk so much as optimize it for your unique condition and style. For example, the young person who won’t have to depend on his or her investments for income can afford to take greater risks in the quest for high returns. On the other hand, the person nearing retirement needs to focus on protecting his or her assets and drawing income from these assets in a tax-efficient manner.
When selecting funds, it is advisable to consider their performance over at least the previous three years to five years. This along with studying calendar wise performance vis-à-vis benchmark indices (like Sensex, Nifty, etc.) and peer group would indicate consistency across time frames and market cycles. Additionally, you could consider the fund’s AUM and period of existence.
Generally, the more risk you can bear, the more aggressive your portfolio will be, devoting a larger portion to equities and less to bonds and other fixed-income securities. Conversely, the less risk you can assume, the more conservative your portfolio will be.
Once the portfolio is constructed, it is very vital to re-assess the portfolio weightings and to re-balance strategically.
Overall, a well-diversified portfolio is your best bet for consistent long-term growth of your investments. It protects your assets from the risks of large declines and structural changes in the economy over time. Monitor the diversification of your portfolio, making adjustments when necessary, and you will greatly increase your chances of long-term financial success.
One should consult his/her financial adviser before making investment in mutual funds.