Among the many things I haven’t really cared too much about, until recently, is the importance of building a good investment portfolio. Indeed, for many of us, investment management and planning tends to be a one-time exercise done in the Jan-Feb time period when we need to show evidence of investments made for the year to our company’s Finance department. Of course, we all realize that this kind of ad-hoc approach is far from ideal. But not many of us really care because we do not realize the impact of our financial misdemeanors in the short run. However, when extrapolated over a long run, this lack of financial planning can definitely make a significant difference to our savings. If I were to tell you that the accumulated loss due to improper financial planning over a 2 decade period could potentially finance a few package trips to your dream global destinations, a dream car and a few down payments for your dream house, then would it make you sit up? It must, because the impact can be surprisingly substantial! So, the best thing to do is to not waste a single moment and get down to the drawing board to build your investment portfolio.
Now how do we go about building an investment portfolio? First of all, it is important to note that there is no set formula for creating an investment portfolio. Different people have different preferences based on their experiences and family investment history. With that said, the key starting goal, for an investment portfolio is that the complete portfolio should generate a return that should beat the prevailing inflation. If our returns are lower than inflation, it leads to an erosion of our wealth. It’s just like burning your money in a bonfire in this case. So, the inflation rate is the bare minimal rate of return that we need to aim for. Currently, the inflation rate in India is a little over 9% and it is being considered quite high. This rate also tends to hover around over the year. But for reference purposes, let’s fix the minimum rate of return to be about 8%.
Now, how do we go about beating this rate of return? There are several avenues we could consider, like equity, debt funds, gold, money market funds and so on. Each of these asset classes have their own historical rates of return. For instance, equities typically give about 14-15%, long-term debt would give about 7-8%, gold would give around 12-13%, money market funds (or short term liquid funds) would be around 5-6%, bank gives 3-4% and so on. Of course, these are long term indicative averages and to be taken with a pinch of salt. The return that we would get would depend upon our timing of entry and exit and the prevailing macro-economic circumstances at each of those instances. It is obvious that we need to diversify the portfolio. We cannot and should not be fully invested in equity as it is the most risky asset class. Similarly, only investing in debt can make our returns too frugal thereby running the risk of not being able to even hit the rate of inflation. Consider the following sample investment portfolio:
Asset Class | % of wealth invested |
Equity | 30-50% |
Debt | 20-30% |
Money Market | 0-20% |
Gold | 20% |
Bank | 10% |
This is not a model portfolio but let’s try to analyze it. It can be seen that an attempt has been made to diversify. Money market funds are short term liquid funds which give higher returns than the bank. So, it’s better to park the money temporarily here (rather than the bank) while we are waiting for investment opportunities. If the environment is looking good for a stock market rally the equity exposure could go up to 50% at the expense of the money market component. If the equity markets are looking overbought and cyclical correction is imminent, it is better to reduce the equity exposure to 30% and increase the exposure of debt from 20 to 30%. But at all points of time, we must at least have 20% in debt and 30% in equity. 20% has been allocated for gold which should be steadily maintained. And the final 10% needs to be kept in the bank for meeting day to day expenses.
In the above portfolio, we can see that about 40-50% of the portfolio is in debt and gold, both of which are generally considered safe havens and the combination should safely generate about 9-10% returns in today's times. Similarly, 30-50% exposure is in equity which if properly handled could give about 14-15% over the year. The balance amount(10-20%) is temporary cash in the money market funds and in the bank which would give about 4-5% return. So, though this component is a bit of a drag, its quite small and unavoidable. Overall if we take a weighted average, the net return of this portfolio could be about 12%. So, in case the total wealth under consideration was Rs. 10 lakh, the investment outcomes after 1 year would look as shown below in the different situations.
In the above portfolio, we can see that about 40-50% of the portfolio is in debt and gold, both of which are generally considered safe havens and the combination should safely generate about 9-10% returns in today's times. Similarly, 30-50% exposure is in equity which if properly handled could give about 14-15% over the year. The balance amount(10-20%) is temporary cash in the money market funds and in the bank which would give about 4-5% return. So, though this component is a bit of a drag, its quite small and unavoidable. Overall if we take a weighted average, the net return of this portfolio could be about 12%. So, in case the total wealth under consideration was Rs. 10 lakh, the investment outcomes after 1 year would look as shown below in the different situations.
Asset Class | Risk level | % return | Amount after 1 year |
Equity | Risky | 14-15% | 11,50,000 |
Debt | Safe | 7-8% | 10,80,000 |
Gold | Reasonably safe | 12-13% | 11,20,000 |
Money Market | Safe | 5-6% | 10,60,000 |
Bank | Safe | 3-4% | 10,30,000 |
Balanced portfolio | Distributed risk and reward | 12% | 11,20,000 |
In the above table, we can see that our balanced portfolio beats keeping the money in the bank by almost Rs. 1 lakh. This should certainly wake up all those among us who keep large sums of money in the bank. Similarly, one could argue, why not just put the entire chunk in gold? Well, as I said before the historical average rates of return may not apply every time. There have been years when gold has given just flat or zero returns. Which is why it is always advisable to diversify the risk.
So you can see, the above portfolio looks like a reasonably attractive way we can beat inflation by about 4%. Similarly, we can have our own portfolios depending upon our risk appetites and age. The most important thing is the realization that we need to start somewhere. We must also make an attempt to track our portfolio at least once a fortnight and be ready to make minor adjustments depending upon the situation. Hence, managing our investment portfolios should not be viewed as a one-time activity but infact an engaging and exciting process of rational experimentation and self-discovery.
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