How do you build a portfolio for retirement and other long-term goals?
It is a multi-step process.
- Decide the Asset Allocation for your long-term portfolio.
- Decide the sub-allocation within the asset class and choose specific investments
- Review and rebalance regularly
#1 The first step is deciding Asset Allocation
The right asset allocation for you will depend both on your risk appetite and your risk-taking ability.
Risk appetite is your behavioural DNA. A few investors don’t bat an eyelid even if the portfolio is down 20-30% while others lose sleep over a 5% fall.
Risk-taking ability is more objective. It depends on your age and your future income prospects. A young earner will likely have high risk-taking ability. To an extent, it is also a function of how much wealth you have (compared to your income needs).
If your risk-taking ability and risk appetite agree, it is an easy choice. For instance, if you are young with high risk-taking ability and high-risk appetite, you should build an aggressive portfolio. Similarly, if you have low risk-taking ability and low risk appetite, work with a conservative portfolio.
What if risk-ability and risk appetite don’t agree? “Low” on either means you shouldn’t work with a very aggressive portfolio.
If you are an old investor with a low risk-taking ability but have a high risk appetite, you shouldn’t work with a very aggressive portfolio.
Alternatively, if you are young with high risk-taking ability but with a low risk appetite, you shouldn’t work with a very aggressive portfolio. However, for such young investors, a conservative portfolio may not be the right choice either.
Sample Aggressive Asset Allocation: 60% equity, 40% debt
Sample Conservative Asset Allocation: 30% equity, 70% debt
By the way, equity and debt are not the only possible assets. You can also consider adding gold. A balanced portfolio could be 50% equity, 40% debt and 10% gold.
#2 Then, look at the sub-allocation
Once you have decided the asset allocation for your portfolio, how should you allocate to sub-assets?
For instance, you decide to put 60% in equity. How much should be in mutual funds and how much in stocks? Within mutual funds, how much large, midcap, and small cap stocks? Or banking or pharma stocks?
While there are many approaches you can take, I work with a core and satellite portfolio approach for both equity and fixed income portfolio.
The rest of the post is devoted to this aspect. Please understand you will still be left with many unanswered questions. The intent is not to give a black and white answer because there is none. For you to explore further.
How do you construct Core Equity portfolio?
The Core equity portfolio has two aims:
- To generate market matching returns
- Diversify equity portfolio
I work with the premise that market-cap based indices are difficult to beat. And there is already a strong evidence, especially in the large cap space in India.
With this premise, you can pick one or two large cap index funds for your core portfolio. Nifty 50, Sensex, Nifty 100, Nifty Next 50 etc.
Secondly, it is important to have international equity exposure in the equity portfolio. This helps diversify the equity portfolio. While there is a dearth of international options in the Indian MF space, you can pick up a fund from the limited options we have.
Alternatively, you can take the LRS (liberalized remittance scheme) route, open accounts with a foreign broker and invest directly from those accounts. You will have a much wider choice. However, that also means extra paperwork (for remittance), TDS (on LRS remittance), tax-filing complications.
Remember, US is the biggest equity market globally. Do consider this when choosing an international equity fund. I bring up this point specifically because I have seen portfolios with exposure to commodity economies such as Brazil or ASEAN or other emerging markets. Now, this can’t be your only international equity exposure (or your core equity exposure).
- 1 or 2 large cap index funds/ETFs
- International Equity Fund (preferably an index fund/ETF)
For this portion of your portfolio, you do not have to worry about the underperformance or overperformance. You are using index funds and merely trying to generate market returns. You do not carry any fund manager risk.
If you are not comfortable with index funds, you can pick an actively managed large cap fund with consistent performance. You can pick up an international fund similarly. However, if you use active funds for your core portfolio, you will have to navigate through bouts of underperformance at regular intervals. This is not easy and causes a lot of confusion in investors’ minds. That’s why, for the core portfolio, index funds/ETFs are a better choice.
How do you construct Satellite Equity portfolio?
With the satellite portfolio, we try to beat the market. Or generate better returns than what the bellwether indices such as Nifty or Sensex would offer.
Note that we try to earn better returns. There is no guarantee of better returns.
A satellite equity portfolio can have:
- Direct equity
- Actively managed funds
- Multicap, Midcap and small cap funds
- Sectoral/thematic funds
- Factor based investments
- Active international equity investments
- Portfolio Management Schemes (PMS)/AIFs
To select funds for your satellite equity portfolio, you need skill and conviction. Moreover, themes will keep coming in and going out of favour. Thus, you may want to reassess your position at regular intervals. And yes, don’t ignore the role of luck if you are successful.
What should be the breakup between the core and satellite portfolio?
There is no fixed answer.
While it depends on your preference, I suggest that the core portfolio should form at least 50% of your overall equity portfolio. 50% is with upward bias. You can even have 100% of your equity investments in the core equity portfolio.
For instance, you pick just 2 funds: a Nifty 500 index fund and an international equity index fund to round up your portfolio. So, everything to the core portfolio and nothing to the satellite portfolio.
Every fund in your portfolio should serve a purpose. And the core and satellite portfolio approach helps you look at your portfolio from that angle. If you can’t pinpoint what value a particular fund is adding to your portfolio, you likely have too many funds in the portfolio, and it is time to get rid of that fund.
How to build a long-term fixed income debt portfolio?
We can follow the core and satellite portfolio approach in the fixed income portfolio.
There are two broad risks in fixed income portfolios.
- Interest rate risk (duration risk): When the interest rates go up, the bond prices go down. And vice-versa.
- Credit risk (default risk): The bond issuer might default.
For a detailed discussion on risk in debt mutual funds, refer to this post.
Core fixed income (debt) Portfolio: You control for both interest rate risk and credit risk. Thus, you invest in instruments where you do not have to worry about defaults and where the change in interest rates will not affect the value of your investments much.
Core Portfolio could comprise
- Bank Fixed Deposits
- Post-office schemes
- RBI Floating rate Bonds (yes, this should fall here)
- Treasury bills
- Government Bonds (if you are buying for interest income)
- Select variants of debt fund schemes (liquid funds, money market funds)
- Ultra-Short or short duration debt funds (with good credit quality portfolio)
- Any investment where you are not bothered about interest rate movements or defaults in the underlying portfolio.
In the satellite fixed income portfolio, you relax on one or both these risks. So, you would invest in:
- Short duration but low credit quality bonds (or mutual funds)
- Good credit quality but long duration bonds (or mutual funds)
- Low credit quality and long duration bonds (or mutual funds)
Franklin debt funds had (1). It didn’t pan out well for many investors. Low credit quality debt usually implodes every few years and will at least give you scares on a regular basis. Avoidable. Or work with low exposure. Covered Bonds would fall here.
(2) is still fine. Long duration government bonds and gilt funds will fall here. Little credit risk. However, these instruments will be sensitive to interest rate movements. Fixed maturity ETFs (Bharat Bond ETFs) or fixed maturity gilt index funds could be a good way to play this theme.
(3) is the domain of experts and should be avoided by retail investors like you and me.
Satellite fixed income portfolio could comprise:
- Corporate NCDs (Non-convertible debentures)
- Corporate Fixed Deposits
- Long duration gilt funds
- Credit Risk Funds
- Covered Bonds/Market Linked Debentures
The boundaries between the core and satellite products may not be very crisp in the case of fixed income products. For instance, fixed maturity ETFs can be part of both core and satellite portfolios. Depends on how you look at it.
What should be the breakup between Core and Satellite fixed income portfolios?
Again, no fixed answer.
However, in my opinion, the core fixed income portfolio should be at least 65-70% of your overall fixed income portfolio. Can even go up to 100%. This is much higher than the minimum I suggested for the core equity portfolio.
Because the purpose of the fixed income portfolio is to lend stability to your overall portfolio. I wouldn’t want to chase very high returns from the fixed income portfolio. To chase returns, we have the equity portfolio. I don’t want to lose sleep over my fixed income portfolio.
#3 Review and Regular Rebalancing
Due to market movements, your portfolio will move away from target allocation.
While you can’t possibly rebalance for every minor deviation from target allocation, rebalance at regular intervals (say annually) or when the target allocation deviates beyond a certain threshold.
Additionally, review your choices in the satellite portfolio (both equity and debt) on a regular basis.