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


How to build a long-term portfolio?

Here’s a way. Choose the best performing fund over the past 12-24 months. After a few months, you realize 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. This will wear you out since every investment choice requires you to put in time and mental effort. You end up paying more attention to your money matter than you should. More importantly, the fashionable investment approach risks being counterproductive in the long run.

I prefer a simple approach that’s easy to execute and stick to, and I’ll share a three-step process for structuring your long-term portfolio.


Three-step process

Decide on a target asset allocation. Decide on 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 stocks, debt, gold, and real estate. The best asset allocation does not exist. 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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Next, we move on to under-allocation within specific assets. Let’s start with your stock portfolio. Divide your stock portfolio into two parts. The main wallet and the satellite wallet.

The core equity portfolio attempts to generate returns in line with the market. The need for a core portfolio begins with recognizing that the markets are hard to beat. With this premise, the best way to replicate market returns is to use index funds or ETFs that track 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 attempts to generate above-market returns. Express your wallet preferences in the satellite wallet. Sector and theme funds, actively managed funds, factor indices, PMS and your equity investments are part of the satellite portfolio.

The allocation between the core and satellite stock portfolio depends on your confidence in your stock or fund selection skills. I suggest an allocation of at least 50% to the core equity portfolio.

Core and satellite approach for fixed income securities

You can also use the core and satellite approach for your fixed income portfolio. Investing in debt involves two major risks. Credit risk refers to the possibility that the borrower will default on payment. In addition, you face interest rate risk as your fixed income investments may suffer if interest rates rise. This happens because interest rates and bond prices are inversely related. When interest rates rise, bond prices fall and vice versa.

The core fixed income portfolio controls both credit risk and interest rate risk. These can be EPFs, PPFs, term bank deposits, RBI bonds, government bonds and short term bonds of good credit quality. Allocate at least 70-80% of your fixed income portfolio here.

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

Revise and rebalance

Finally, review and rebalance your portfolio at regular intervals. The portfolio review helps you assess whether your portfolio is moving in the right direction. It also helps to check if an investment is serving the intended purpose in the portfolio. Take corrective action if necessary.

Portfolio rebalancing brings your asset allocation to target levels. This would require transferring money from the asset that performed well to the asset that struggled. So, if stock markets have done well, your rebalancing rules will require you to move money from equity investments to debt. Alternatively, if stock markets have struggled, you will move money from debt to stocks.

With this simple rules-based approach, you don’t have to worry about whether to sell since the markets have risen too much or whether to 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 revisions and rebalancing is also important. Do it too often, it will be a drain on your time and you are overreacting to short-term performance. There is also a cost. If you’re too lazy, you might miss entire market cycles. An annual review and rebalancing frequency is fine. You can also rebalance when your allocation to an asset deviates from the target allocation by more than 5%, for example.

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

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


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