Constructing an effective investment portfolio often proves to be a challenging task for most new investors. Not constructing a portfolio effectively right from the beginning leads to significant issues in future years. Therefore, today I will share simple guidelines that first time investors can use to effectively construct portfolios.
Before setting up an investment portfolio we must first have clarity on the following aspects :
1. What our financial goals are (What we really want to achieve with our money)
2. The time horizon for each of our financial goals (How long it would likely take to fulfill each of our goals and aspirations)
3. Our risk profile (how much risk we can afford to, and are willing to take)
4. The prevailing rate of inflation applicable to us as per the cost of our individual financial goals and lifestyles (usually 8-10% per annum)
Our portfolios and product choices must be an optimal fit for us in light of these aspects. An effective portfolio is one built with a balance between various asset classes in a phased manner over time. Where goals have varying time horizons, a standalone portfolio can be designed for each goal.
Finally, investors who are just starting out must look to restrict themselves to tried and tested product options within each asset class.
Having understood the general approach new investors should ideally use to construct their portfolios, let us now look at a basic understanding of each major asset class they can use in their portfolios and ideal product options within each asset class. The first major asset class is equity. Equity as an asset class is undoubtedly essential to power long term portfolio growth. But returns from equity can fluctuate significantly and cause severe drops in portfolio value especially in the short term. And these drops in value can last for considerable periods of time. Therefore, too much exposure to equity can drive up the risk of the portfolio. Also exposure to the wrong kind of products within the equity universe can cause severe and lasting drops in portfolio value. Therefore, it is best for new investors to provide for their equity component through passively managed index funds that track a major market index (like the Sensex or the Nifty 50). Once investors get comfortable with the kind of risks involved with index funds after a few years, they can consider moving on to more risky options such as actively managed mutual funds or individual stocks. But there is no necessity to do so. Building our equity portfolios purely with index funds is enough to help us meet our long term goals.
Debt is an asset class that balances out the high degree of risk inherent with equities. They can also provide investors a stream of additional income. Contributions to retirement schemes offered by our employers can form the core of our long term debt portfolios. Public Provident Fund (PPF) and Sukanya Samriddhi Yojana (SSY) accounts are also suitable for long term goals. Low risk options within the debt mutual fund options such as liquid funds and overnight funds can also be considered. They provide liquidity to the debt portfolio. For short term goals which are less than 7 years away, first time investors can simply stick to savings bank deposits, fixed deposits and recurring deposits.
Now let us look at some general guidelines on portfolio construction for first time investors. Firstly, portfolios for goals which are 7 or more years away must have a minimum allocation of 50% to equity. But the allocation to equity must ideally not exceed 60%. Goals that are less than 7 years away can easily be achieved with a mix of FDs and RDs. Finally, it is better for first time investors to remember not to chase returns in the the debt component of their portfolios. A 7% post tax return from long term debt portfolios would be more than sufficient.
In conclusion, all first time investors should focus on education, simplicity, behaviour and survival during their first few years. The focus for investors during this period should be to educate themselves about the investment products and asset classes they invest in. They must look to pick the most simple and easy to understand products within each asset class. They must investing with a clear strategy having gained clarity on their financial goals. This means that any first time investor's portfolio must be constructed to a moderate risk orientation. From that point steady, sustainable returns are merely a natural byproduct of the process. And that is the hallmark of effective portfolio construction.
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