Building A Mutual Fund Portfolio - 1

Much has been written about building a mutual fund portfolio. You can try Money Control, Rediff, Value Research, PersonalFn etc for tons of good articles on the subject. However, there is a common problem with all these articles. They give you a ton of funda but don't really tell you how to go about building a portfolio.

This post is the first of a series of posts I will do on the subject. In these we will look at the various factors involved and we will actually build a portfolio(s).

To start, we will assume the following:

1. Age: 35 years
2. Married with two kids.
3. Investable surplus of Rs. 12,000/- per month
4. Other issues like Insurance, Real Estate, PPF, Tax Planning etc already taken care of.

Investing for:

1. Retirement
2. Children's College, Higher Education & Marriage
3. Floating Fund for periodic large expenses (car, vacation etc)

Lets look at each investment target:

Retirement

Assuming a retirement age of 60, we have 25 years to go. This is a very long time! So we can have a pure equity (diversified) portfolio. More on this later.

Children's College & Higher Education

Assuming two children with say a difference of 5 years between them, we are looking at a time range of 10 & 15 years (say). Again a long enough time frame for a pure equity (diversified) portfolio. More on this later.

Floating Fund for Periodic Large Expenses

This one is trickier. Let us break it down a bit. Let us assume we will use this portfolio to build up a corpus over a fixed period and then empty it, starting again for the next block. Let us assume we will use blocks of 3 years each. Now 3 years is a short time frame but still adequately long enough to have a significant equity exposure. But we are definitely not talking about a 100% equity exposure here. Also, this would typically be our least priority among the three portfolios we want to setup.

Given the above we can settle for a 60 - 40 or even a 70 - 30 equity - debt distribution. This is easier said than done! We will have to do some homework for this one!

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Now lets us look at some concepts:

Risk

I have not spoken of "Risk" so far. Risk is a relative term. It varies from person to person. And risk is a perception rather than an quantifiable entity. That is, we cannot say something like "my risk appetite is 25%" or "my risk appetite is low / medium / high" because it does not make sense. What is low risk? No such thing exists!

So what are we talking about here? Risk to me is about calculation. Note that one of our key assumptions is about the quantum of money that is available for investment every month. If you are squeezing your finances to come up with this amount, then you are taking risk. If this amount is coming from your income after your regular expenses (household, tax saving, insurance, loan payments, financial buffer etc), then your risk is low. Low mind. There is still the risk of losing the money you are investing. But that does not put your family and lifestyle at immediate financial risk. Rather the risk is spread out over a longer period and hence more manageable.

Return

Okay. Now for the interesting part. And the dangerous part. One of the first things we need to understand when designing a portfolio is what kind of return we can generate. The euphoria of the last few years has people dreaming of "doubling their money in a little while". This is only a pipe dream. Pleasant to dwell on but a chimera nevertheless. It is very important that we understand the kind of returns we can expect from our portfolios.

Historically the BSE SENSEX has returned about 18% per year. This is an average value of course. There have been bad years and good years. However this 18% figure is good estimate of the kind of returns we could expect. But then "past performance is no guarantee..." etc etc. So for our purpose let us assume a return of 15% per annum.

Targets

Ah!. How much? Big question. No straight answers. All I will say at this time is that we need to have a target before we can proceed. For the time being let us throw some numbers out:

1. Retirement - 1 crore
2. Children's Fund - 15 lacs each, or 30 lacs together. Note different time frames! 5 year time difference. So a better target is 13 lacs for the first child and 17 lacs for the second.
3. Floating Fund - 2 lacs

Do these numbers make sense? Not at this time. They are just numbers. But we will go with them for the time being. Later I will revisit the topic of setting targets and show you how to do a good job of setting reasonable targets.

Last Words

So far I have only laid out some assumptions and touched upon three items, namely Risk, Return & Targets. I have made some statements about portfolio structure but have not elaborated further. I will come back to each of these topics later.

In the next post we will look at stitching these things together.