The investor of the twenty-first century is spoilt for choice. With every asset class offering multiple options, there are so many good investments that choosing the right one can be overwhelming. Also, there is an added risk of putting all your eggs in one basket. Hence, the new-age investor tries to create a portfolio of investments instead of investing all the funds in one/two. When it comes to mutual fund investments, a portfolio approach is recommended over buying a single fund too. Today, we will be looking at how you can build a mutual fund portfolio that works for you.
A Portfolio Approach to Investing
Successful investing requires a careful section of assets keeping your financial goals, risk tolerance, and investment horizon in mind. However, it is also important to ensure that you monitor the performance of your investments regularly and make changes if needed. To create a diversified portfolio, you need to invest in multiple asset classes. Hence, you will have different investments to track and monitor. With an investment portfolio, you can have all your investments in one place making it easier to manage them.
While mutual fund investors don’t have to worry about making purchase/redemption decisions about the assets in the fund, they need to monitor the performance of the fund to assess if it is performing as expected. Underperforming funds can be replaced with more promising ones to boost the returns from mutual funds.
Here is a step-by-step guide to help you create a mutual fund portfolio:
Step 1: Understand your investor profile
There are three things that determine the profile of an investor:
- Financial goals or purpose of investing. These include buying a house, marriage, retirement planning, etc. A goal can also be about earning x% returns over the next 5 years, etc.
- Risk tolerance. Every investment carries some risk. It is found that, usually, risks and returns have a direct relationship. This means that instruments with higher risks tend to generate higher returns and vice versa. While every investor would want to earn the highest returns on investment, it is important to assess the risk that you are comfortable taking.
- As investors, you might go through cycles of high, moderate, and low tolerance to risks. Hence, before making each investment, assess your risk tolerance carefully.
- Investment horizon. The time you allow your money to work for you usually determines the returns you can expect. While in the case of fixed-income investments, it increases the interest income, in the case of stocks, it allows you to earn good capital appreciation as the markets rise with time. Knowing your investment horizon will come automatically to you once you know what your goals are. For e.g.: if buying a house is a goal, you would know when do you need it and when do you want to make your first payment towards it.
Step 2: Choose the right MF categories
There are many categories of mutual funds to choose from. Within equity funds, there are schemes with varying risk levels. For example, a large-cap mutual fund may have a lesser risk than a small- or mid-cap fund. Within debt funds as well, credit risk funds may have a slightly higher risk level than a few other peer categories.
Both debt and equity funds have sector-wise exposure. For example, there are banking and PSU debt funds that lend to banks and PSUs only. In equity funds, there are pharma funds, banking funds, tech funds that buy stocks of certain companies belonging to certain sectors only.
So your research does not end with deciding how much you need to invest in equity and debt respectively. There are multiple schemes under the two broad categories that have varying risk levels.
You can also choose between two popular investing styles:
- Value Investing: The market is driven by investor sentiment. Value investors believe that the stock price doesn’t always offer an accurate view of the company’s performance. Hence, they evaluate the company’s intrinsic value to identify stocks that are undervalued and good investment opportunities.
- Growth Investing: Growth investors don’t worry about the value of a stock. They are more concerned about the growth rate of the stock and choose ones that have the potential to grow faster than their peers.
Step 3: Pick the right mutual funds
After going through the above two steps, you will have clarity about the funds that can work for you. Most mutual fund investors stumble at this point. All data available is from the past. While it can offer information on how the scheme has performed in the past, the returns will depend on how it performs in the future. But, how does one predict the future? So, how does an investor pick the right mutual fund scheme?
While there are several things that you can analyze, most experts recommend focusing on three essential aspects as explained below:
- Risk-adjusted returns – Risks and returns are two aspects that can help you identify a fund’s performance. While returns are directly proportional to risks, looking at them in isolation cannot paint the right picture. If a fund has generated good returns, then you must analyze if they are due to good investment decisions by the fund manager or higher exposure to risks. Looking at the risk-adjusted return will help you compare schemes and choose the best ones.
- Performance across market cycles – If you are investing for the long-term, then your money will go through several market cycles. To meet your goals, it is important to ensure that the fund will survive these cycles. Again, predicting the future is impossible. However, you can look at the performance of the fund during difficult market periods in the past and assess how the fund manager has ensured performance.
- Expense Ratio – While generating returns on investments is challenging enough, every mutual fund scheme charges some amount as fund management costs that can corrode the returns. This is charged in the form of an expense ratio. This can be an important aspect while finding the right scheme.
Step 4: Monitor and rebalance regularly
To achieve your financial goals, it is important to stay on top of your investments. Since a portfolio offers a bird’s eye view of all your investments, it allows you to monitor and manage them with ease. While stocks require more frequent monitoring, you must ensure that you check the performance of your mutual fund investments regularly too. If you find that some investments are underperforming, then you can redeem and replace them with more promising funds.
Using this framework, you should be able to create a portfolio of mutual funds that works towards achieving your financial goals. While there are many other aspects to building a perfect one, this should get you started.