A simple, 3-step approach to build a long-term investment portfolio

A simple, 3-step approach to build a long-term investment portfolio

Decide a target asset allocation, choose the investment products, and review and rebalance your portfolio regularly

How do you build a long-term portfolio?

Here is one way. Pick the best performing fund over the last 12-24 months. After a few months, you realise that your funds are no longer the best performing funds. You replace your funds with the new best performing funds. Repeat.

This approach has obvious problems. It will drain you since every investment choice requires you to expend time and mental effort. You end up paying more attention to your money matter than you should. More importantly, the flavour-of-the-season approach to investments is likely to be counterproductive over the long term.

I prefer a simple approach that is easy to execute and stick with, and will share a three-step process to structure your long-term portfolio.

Three-step process

Decide a target asset allocation. Decide the sub-allocation with an asset and choose investment products. Review and rebalance regularly.

Asset allocation means how much to allocate to various assets, such as equity, debt, gold, and real estate. There is no such thing as the best asset allocation. The right asset allocation for you depends on your risk appetite. Aggressive investors can work with a higher allocation to risky assets while conservative investors can control their equity exposure.

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Then, we move to sub-allocation within specific assets. Let us start with your equity portfolio. Divide your equity portfolio into two parts. The core and the satellite portfolio.

The core equity portfolio tries to generate market-matching returns. The need for the core portfolio begins with an acknowledgement that the markets are difficult to beat. With this premise, the best way to replicate market returns is to use index funds or ETFs tracking large cap indices such as Nifty 50 and Sensex. Add a broad-based foreign equity index fund to diversify the equity portfolio.

The satellite equity portfolio tries to generate market-beating returns. Express your portfolio preferences in the satellite portfolio. Sectoral and thematic funds, actively managed funds, factor indices, PMSes and your stock investments belong to the satellite portfolio.

The allocation between the core and satellite equity portfolio depends on your confidence in your stock or fund picking skills. I suggest a minimum 50 per cent allocation to the core equity portfolio.

Core & satellite approach for fixed income

You can use the core and satellite approach for your fixed income portfolio, too. The debt investments carry two broad risks. Credit risk refers to the possibility that the borrower may default on payments. Additionally, you face interest rate risk since your fixed income investments can suffer if the interest rates were to rise. This happens because the interest rates and bond prices are inversely related. When interest rates go up, bond prices fall and vice-versa.

The core fixed income portfolio controls for both credit and interest rate risk. It can include EPF, PPF, bank fixed deposits, RBI bonds, government bonds and good credit quality short duration bonds. Allocate at least 70-80 per cent of your fixed income portfolio here.

The satellite fixed income portfolio controls one or neither of the two risks. Credit risk funds, long duration bond funds and new age credit products will fall here.

Review and rebalance

Finally, review and rebalance your portfolio at regular intervals. Portfolio review helps you assess if your portfolio is moving in the right direction. This also helps check if an investment is serving the intended purpose in the portfolio. Take corrective action if required.

Portfolio rebalancing is bringing your asset allocation to target levels. This would require moving money from the asset that has done well to the asset that has struggled. So, if the equity markets have done well, your rebalancing rules will force you to move money from equity investments to debt. Alternatively, if the equity markets have struggled, you will move money from debt to equity.

With this simple rule-based approach, you need not worry about if you should sell since the markets have risen too much or if you should buy since the markets have fallen sharply. Your asset allocation and rebalancing rules will tell you what to do.

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Timing is critical

The frequency of review and rebalancing is also important. Do it too often, it will be a drag on your time, and you react too much to short-term performance. There is a cost attached too. If you are too lazy, you might miss out entire market cycles. An annual review and rebalance frequency is just fine. You can also rebalance when your allocation to an asset deviates from the target allocation by more than say 5 per cent.

This may look like a very simple approach to investments. However, when it comes to investments, simple beats complex most of the time. And yes, always remember: Costs are permanent while the returns are not. Keep costs low.

The author is a registered investment advisor, and writes at www.PersonalFinancePlan.in.

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