Building a fund portfolio

What should your first step be after you decide to invest in a mutual fund? Call up a broker for application forms? No, that comes much later. Look up the “Best Mutual Funds” issue of this magazine? A flattering thought, but you’re wrong again. In fact, the first step of investing process should not be about investment at all. Instead, it should be about what you intend to do with the money. You need to define the purpose of your investment and the amount you need to achieve this goal.

Perhaps you are planning to upgrade to a bigger car, in which case, you’ll need about Rs 1 lakh as down payment next year. Or maybe you want to send your daughter to a foreign university when she finishes college? It costs about Rs 10 lakh, but you have 15 years to go. Building a nest egg? Or just saving money to buy a home theatre system? Whatever your financial goal and its tenure, you can achieve it through a well-diversified mutual fund portfolio. Here are the three stages to help you create one:

STEP 1: DEFINE YOUR GOALS
As a first step, categorise your financial goals under three broad heads. Anything less than three years is short term, between three and seven years is medium term and everything beyond seven years is long term. The time available for each goal defines the kind of fund used to reach it. A short-term goal requires a fund that does not invest in volatile instruments such as shares. A long-term goal does not need low-yield bond funds.

STEP 2: ASCERTAIN RISK TOLERANCE
The type of investor you are also plays an important role. If you are easily unnerved by stock market ups and downs, it won’t do any good to take on a large equity exposure. But if you can stomach risks, an equity fund can help you reach your financial goal faster than a debt fund. It all depends on how comfortable you are with the risk.

The type of financial goal also has a bearing on the choice of fund. Within each category, there will be flexible goals that can be postponed, and rigid ones that allow absolutely no compromise. A foreign holiday can be pushed back by a few months, even by a year, if necessary. So you can take a little risk.

“Since this goal can be postponed in extreme cases, having an equity exposure makes more sense,” says Chandigarh-based certified financial planner Jaideep Lunial. But paying for your son’s admission to an engineering college can’t be pushed beyond the deadline. In this case, stick to safe and steady fixed maturity plans (FMPs).

STEP 3: DECIDE ASSET ALLOCATION
Once you have the goals in place and have assessed your risk level, you can work out an allocation plan for your investments. Remember, your most important investing decision is not which fund to buy but how to split your money among different kinds of funds. Asset allocation is vital to any financial plan and effectively regulates the volatility and returns of a portfolio.

For each financial goal, there should be a core group of funds, which should typically account for 70-80% of your investment under that head. This core group should comprise steady performers that deliver modest, but consistent, returns. There should be debt funds and FMPs for the short term, and diversified equity, balanced and index funds for the long term.

The balance 20-30% goes into a satellite group of funds that can add zing to your portfolio. These funds would carry a higher risk and would include mid-cap, sectoral and smallcap funds. They have the potential to deliver extraordinary returns but are riskier than diversified equity and index funds. However, as long as you do not allocate more than 20-30% to the satellite group, this risk will not threaten your overall portfolio returns.

The composition of the core depends on the tenure. If your goal is short-term, you can have 100% of your investment in the core, which can comprise just one or two funds. But for long-term goals, the core group would be fairly diversified, with as many as four or five funds.

Money Today has worked out the allocation plan for two shortterm, medium-term and long-term goals (see tables), listing out the categories of funds that can help achieve these goals. Once you have worked out the asset allocation plan and decided on the kinds of funds, picking the right scheme is fairly easy. The Money Today-Value Research ranking of the best mutual funds in our 21 August 2008 issue tells you about the best schemes across six categories.

The process does not end here, especially if you are investing for a long-term goal. With time and as you approach your goal, rejig your portfolio’s composition to reduce its exposure to risky assets like equities and shift to more steady debtbased funds. But don’t do this too often. Rebalance the portfolio every 6-12 months and you should reach your financial goals comfortably.