How to build a first class portfolio?

There’s no dispute that equity (either stocks or equity mutual funds) should be a significant part of the investment portfolio of most people seeking solid growth in capital. We covered this in detail in Make your portfolio safer with risky investments and Is equity all that risky?

After all, over time, shares tend to produce higher returns than investments like bonds and cash. But should they be your only investment? Probably not.

The rationale is tied to practical considerations as well as to the oldest cliché since sliced bread (it features eggs and baskets, if you’re wondering).

First practical consideration: most people own or are paying off their own home. It may not feel like it, but that’s automatic diversity! So fond are some people of this concept, in fact, they over-invest in residential property, and for some people, it becomes their only substantial investment. Buying a home has a whole range of benefits that have little to do with money – as well as some that do. For instance, the majority of people who buy a place to live see its value increase over time.

Second practical consideration: everyone needs money to live on now, and for the proverbial rainy daytomorrow. Whether you think of it this way or not, you already have some exposure to cash. Plenty of people also have some capital tied up in term deposits.

It’s more than likely, then, that you already have positions in at least two, but quite possibly every one, of the four major asset classes: cash, fixed-interest securities (bonds, debentures, fixed income funds), property (your home), and shares.

The problem with having all or too much of your portfolio in any one of these asset classes is that, if one has a terrible year, your whole portfolio has a terrible year. If that one asset class has three terrible years in a row, so does your portfolio. This is known in the business as market risk.

It is also highly likely that after one or two years of poor returns from shares, many investors will instinctively do something to make those returns even poorer (like switch their whole portfolio to cash).

But if you need to free up some money unexpectedly during a low period in markets, you may be forced to sell out of some investments at low prices. The answer to this dilemma, of course, is diversification – spreading your eggs around a number of different baskets.

The most favourable aspect of diversification is that market risk is spread over multiple asset classes and therefore the volatility, or ups and downs of your portfolio, are reduced.

One of the clever mathematical characteristics of diversification is that as you add an extra investment to a portfolio, it reduces the amount of risk for a given portfolio return – the proverbial “more bang for your buck”. However, this is true only up to a point!

The very whiff of a diversification conversation sends professional fund managers into frenzies of discussion about Markowitz efficient frontiers, risk and return trade-offs, strategic long-term portfolio asset allocation strategies, tactical tilts, efficient markets theories, value overlays, tracking errors, and so on.

That’s fine for the professionals, but for most people, diversification basically means it’s a good idea to hold a range of other assets to help protect your portfolio when shares (or any other investments) go through a rough patch.

Within equity too, it makes sense to diversify. And this is what diversified equity funds attempt to do. A typical diversified growth fund, looked after by a professional manager, will invest in numerous sectors and stocks within those sectors. Some funds will even have an international allocation. Some of those stocks could be value picks, some could be growth. Some will be large caps, some will be mid-cap stocks.

Or, you may decide that you wish to invest in international stocks with a proportion of your savings. There are plenty of funds which will give you that exposure.

If you scorn diversification, one word of warning – don’t underestimate the psychological pressure of a falling market. Plenty of “disciplined, long-term investors” have been known to buy high and sell low when it looks like the world is collapsing.

Finally, the most important factor is to keep in mind is the minimum timeframe for long-term investment in the share market (three to five years), and make sure your share portfolio has time to work for you.

If you can’t commit the money for that length of time, stick to short-term deposits and cash until you can free up some committed capital.

Building your equity portfolio: first consideration

Before you go out and buy every worthwhile stock or equity fund you can find, it’s worth putting some thought into the type of portfolio you’re trying to build. We’ll be talking here about building a first-class investment portfolio for managing your core allocation to equity.

Long-term investment is an approach that works for most people, most of the time. Speculation (be it in stocks or betting on sector funds which will ride a particular theme) as an investment strategy – rather than simply as a small component of a strategy – works for a few people, some of the time.

So, what type of share portfolio should you build? A mixture of capital gain and income? Pure capital gains – a return that’s higher than the market over time.

Do you want market returns? They maybe you should stick to an index fund. Or, do you want to “beat the index”? Then first decide which index – Sensex, Nifty, BSE 100, BSE Mid Cap, and so on and so forth. Figuring out which index is far from your only consideration. Assuming your basic aim is to beat the index, you will need to understand exactly what it is you’re trying to do better than. You also have to consider how much you want to beat it by, and what level of “risk” you’re prepared to accept in achieving that.

How many funds should you buy?

It depends on how much time you have, how large your portfolio is, your access to information, and what you’re hoping to achieve from investing. But remember, there is such a thing as over-diversification.

Investors often ask how many funds they should have in their portfolios, and the answer a safe answer is: “as many as you understand”. You must understand the investment mandate and strategy of the funds you invest in. Or else, how will you monitor their performance adroitly?

Let’s assume you are in your 20s and can spare Rs 5,000 per month. In that case, you can start off with two equity funds – a large cap and a mid cap. As you build up your experience and your portfolio, you may wish to aim for a final holding pattern of around six to seven funds.

If you already have a portfolio in place, check whether you have adequate exposure to equity or are heavy on debt. Also check for duplication of funds – too many large cap funds, too many mid cap funds? If you have too many thematic funds (like infrastructure) or sector funds, you could try and offload those.

We suggest you take a look at Do your holdings pass the decluttering test?

A basic “rule” of building a portfolio is diversifying. But there’s no need to get overly scientific about the whole thing. For most people, buying a range of equity funds makes sense simply as a form of insurance policy against making mistakes.

Studies conducted by psychologists have consistently found that people are tirelessly optimistic about their ability to do most things. The highway is full of poor drivers, yet how many of us will ever admit to being dangerous behind the wheel?

That’s why we take out car insurance – and that’s why it usually pays to take out “insurance” against those calls you get wrong, by diversifying your portfolio. It is not just a boring defensive strategy. It will give you the opportunity to reach your financial goal.