Here are the 6 steps that you need to follow.
1. Start off with your long-and medium-term goals in view
Goals are essentially dreams that can be quantified. For example, a comfortable retirement is a dream but to put a monetary value to it is a goal. Once you have your retirement corpus and tenure in front of you, the next step should be to design a portfolio that meets these goals. Same is the case with educating your child. It is a huge investment and also needs to be planned for in terms of the corpus and the liquidity at various milestones. Then, there are medium-term goals like arranging the margin money for your home loan or for a foreign holiday. This must be the starting point for your mutual fund investment.
2. Design a mutual fund portfolio that is based on these goals
You have an approximate idea of how much your goals will cost at a future date. You also have an idea of how much return you will require to achieve these goals. The table below captures the following matrix.
|Goal||Target Corpus||Invested in||CAGR Returns||Monthly SIP|
|Retirement||Rs2cr in 20 years||Equity Funds||14%||Rs15,194|
|Child Education||Rs1cr in 15 years||Equity Funds||14%||Rs16,317|
|Home loan margin||Rs10 lakh in 4 years||Debt Funds||8%||Rs17,629|
|Foreign Holiday||Rs3 lakh in 3 years||Debt Funds||8%||Rs7,352|
|Total SIP Monthly||Rs.56,492|
The investor now needs to spread his investments across equity and debt funds as above with a monthly allocation of Rs56,492 to be able to achieve his long- and medium-term goals. This is how mutual fund asset allocation is done at the macro level. Then, you get into the mutual fund specifics.
3. Break up your mutual fund portfolio into Core and Satellite
What do we mean by a core and satellite approach to mutual fund portfolio creation? We have seen that the above goal allocation requires a certain amount as SIP each month. This must be in the form of a monthly commitment, and one must make this the core portfolio. Here, the focus is not about opportunities or booking profits. Instead, the idea is to match goals with investments and keep reviewing and rebalancing on a regular basis. The satellite portfolio is more of an opportunities portfolio. For example, if you are able to create a monthly surplus above the stated goals, this can go into opportunistic ideas like slightly higher risk debt funds, sectoral and thematic funds, etc. Another example of satellite allocation is when you receive an annual bonus, capital gains, or a lumpsum inflow. Either ways, be clear not to disrupt your core portfolio in any manner.
4. Your risk tolerance matters more than risk appetite
There is a difference between risk appetite and risk tolerance. You may have the risk appetite of a seafarer but that is not what is required. You risk tolerance is more pragmatic. It is based on your age, your income level, your assets, your liabilities, your family commitments, etc. The mutual fund portfolio must be designed with your risk tolerance in mind. For example, a sector fund may be a good product, but if you are 50 years old and up to the neck with commitments, you just don’t have the risk tolerance for it.
5. Create a mix of fund categories
Any mutual fund investment is a trade-off between risk and returns. This is why you must always evaluate the fund on returns and also risk-adjusted measures such as Sharpe and Treynor ratios. If the fund manager is generating 2% higher return with 30% higher standard deviation, then it is not meant for you. Even in your core portfolio, talk to your financial advisor and see how best you can make a mix. A G-Sec fund may be default-free but could take a hit if rates are going up. The best long-term wealth creator may be a multi-cap fund and not a large cap fund. These are issues to factor in when you create the fund mix.
6. Constantly review and rebalance your mutual fund portfolio
A mutual fund portfolio, once created, can never be static. Your core portfolio should be regularly reviewed based on whether it is in sync with your goals and the regular milestones. Even the core portfolio can be changed if you are invested in products that have not worked for you. In your core portfolio, you have defined percentages. If it is off these percentages, it calls for rebalancing. For the satellite funds, you must review periodically based on the changing macros and industry developments.