For a new investor, the first important decision could be which asset class to invest in and in what proportion. It is important because asset allocation lays solid foundation for a successful portfolio.
Similarly, for an existing investor, the decisions could be pertaining to weeding out non-performing investment options in the portfolio and the need to rebalance the portfolio from time to time. Investors react to these situations differently and hence take these decisions with varying degree of success.
Considering that mutual funds are an ideal investment vehicle for investors with varying risk profile and needs, here are a couple of important decisions that can play a significant role in the kind of success they achieve from their portfolios over time:
Portfolio composition in different market situations
Investing in different type of funds, especially equity funds, in different market situations can be a little tricky for investors. One often comes across cases wherein even those investors who begin their investment process by following an asset allocation strategy and selecting funds appropriate to their needs get tempted to invest in funds that have been performing well for the past few months or quarters.
They believe that by investing in such funds they can benefit from the momentum in the stock market. No wonder, they end up investing pre-dominantly in aggressive funds like mid-cap, sector as well as thematic funds. While these funds have the potential to perform better than diversified funds, there are attendant risks too.
Hence, this sudden aggression in the portfolio composition often takes them beyond their risk-taking capacity. Therefore, when they are faced with market downturns, they feel compelled to make some haphazard decisions. While it is true that even the most diversified and high-quality funds also suffer from market downturns, the impact may be much less.
Similarly, during volatile and subdued market conditions, investors look for stability and invest pre-dominantly either in pure large cap or large-cap dominated funds. However, by doing so, they miss out on investing in the mid-cap segment at attractive valuations, which impacts their portfolio performance in the long run.
Therefore, one must decide the allocation to different asset classes and different segments at the beginning of one's investment process and stick with it during one's defined time horizon. Having a well-diversified portfolio helps as different market segments behave differently over different time periods.
Of course, there could be situations that may require an investor to rebalance the portfolio both in terms of allocation to an asset class as well as different segments of the market.
Remember, making changes in the portfolio composition based on the changes in one's personal situation or in line with one's investment strategy helps in maintaining the right balance between risk and reward. It's only ad hoc decisions that affect the performance of the portfolio either by exposing investors to higher risk or by way of missed opportunities.
Deciding when to sell a fund
It is good to see more and more investors taking so much care while making investment decisions. However, when it comes to make a selling decision, many of them still act in a haphazard manner.
While equities are essentially a long-term investment option, different investors may have different reasons to cut short the holding period. Whatever the reason, it is important to have a proper strategy to avoid taking decisions that are dictated by emotions rather than any logic.
Investors often make the mistake of either holding onto funds for too long or exit in a hurry. One needs to do a thorough analysis before taking a decision to sell. It is quite common to see investors err on the side of selling funds without giving them time to show what they can do. Poor short-term performance should not be the reason for selling a fund.
It is important to hold a fund long enough to evaluate its performance. That's why the track record of the funds in the portfolio has to be carefully evaluated. Remember, a long-term track record moderates the effects of unusually good or bad short-term performance on a fund's track record. Besides, longer-term track record compensates for the effects of a fund manager's particular investment style.
However, if one ends up building a hodgepodge portfolio, it should be pruned at the earliest. Generally, one can begin by selling funds that have lagged behind their peers i.e. other funds in the same category. It is important to know here that the performance of a scheme is best measured in terms of total returns.
Total return is the percentage of change in the Net Asset Value (NAV), with the ending NAV being adjusted to take into account the dividend distributions made by the fund.
The lack of discipline in a fund manager's investment approach could also be a valid reason for selling a fund. The pressure to perform can make a fund manager change tracks in terms of sectors as well as stock selection.
In other words, while analysing the performance, the objective should be to differentiate investment skills of the fund manager from luck and to identify funds with the likelihood of future success.
Another reason to sell a fund can be when it outlives its utility to an investor. It could be because of change in his needs, risk profile and time horizon. A situation like this would generally require an investor to carefully examine his changed circumstances before realigning the portfolio.
(Hemant Rustagi is CEO of Wiseinvest Advisors)