1. Identify Your Goals
The first step towards building a mutual fund portfolio is to identify the goals you are building that portfolio for. Having goals is important because all your further decisions will be anchored to them. Investing without a goal is just like boarding a train without a destination in mind. These goals can be anything: investing in your dream house, planning for your children’s education, investing for your retirement, etc.
Goal identification also helps you decide the time horizon. That can help in determining the level of risk you can take. The longer the horizon, the more risk you can take. Conversely, the shorter the horizon, the lower the level of risk.
2. Select Investment Avenues Based on Your Time Horizon
Once you have identified your goals and their time horizon, you can proceed to select the right investment avenues for each of them. For example, if you have a short- to medium-term time horizon (one year to three years), you can invest in short- to medium-duration debt funds and stay away from equity. Equity funds are not suitable for short-term goals because their inherent volatility can result in a loss.
The table below shows the minimum number of years you need to stay invested in different equity indices to make sure you earn positive returns. Generally speaking, you must have a horizon of five to seven years while investing in equity funds. If your time horizon is less than that, debt funds or hybrid funds would be the ideal choice.
3. Diversify Your Investments
Once you have identified your goal and asset classes that are suitable for them, the next step is to diversify your investments across the assets/avenues you identified in Step 2.
For example, let’s say you want to save and invest in your child’s higher education and have a time horizon of 10–12 years. In this case, you should invest predominantly in equity but not in equity alone. It would still be prudent to include gold and debt components in your portfolio as they can reduce the volatility of your portfolio, without hurting your total returns significantly. This will help you stay put when the equity markets enter the doldrums.
So, you can decide on an asset allocation percentage depending on the level of risk you can take. For instance, you can allocate 60% towards equity, 30% towards debt, and 10% towards gold.
Further, not only should you diversify your investment across asset classes but you should also diversify your investment within the same asset. For example, you can invest in large-cap, mid-cap, and small-cap funds within your equity portion. Having mid- and small-cap funds can also give a kicker to your returns in the long run.
4. Start Investing through SIPs
This is the most important step. Execution is more important than planning, and many investors, even after doing the above three steps, postpone their decision to invest. One reason investors procrastinate is due to their lack of experience in investing in equity funds and hence the fear of losing money in the market.
The solution to the above problem is to start small. Then once you have gained more experience, you can gradually increase your investment amount. It’s important to start because unless you start you will never be comfortable with equity. Further, for most investors, SIPs are the best way to invest. SIPs don’t just instill discipline in investment behavior but also help you average your investment cost over time, thus reducing the impact of volatility on your returns. What’s more, you can start small SIPs and slowly increase them as you gain more confidence.
5. Review and Rebalance
The final step is to review and rebalance your portfolio. The frequency of this exercise is up to you, but it should be done at least annually.
Here, you will revisit steps 2 & 3, where you identified different asset classes and decided the asset allocation. Over time, it is possible that some of the asset classes have rallied and your asset allocation is out of balance Therefore, taking stock of the situation and rebalancing your portfolio is important to bring it back to your desired asset allocation.
Also, during this exercise, you can review the performance of active funds in your portfolio. If they have been underperforming for two or more years, you can decide to switch to better ones.
Conclusion
The above steps can be used as a broad framework to build your own mutual fund portfolio. But remember that investing and planning for your goals is not a one-time exercise. It has to be done on a continuous basis, and you may have to revisit the above steps at different points in time.
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