How to Create a well-balanced Portfolio?

What is an ideal portfolio?

Is there something called an ideal well-balanced portfolio? This is like asking if there is something called an ideal weight loss diet. In much the same way as an ideal diet for weight loss that would fit all, sounds absurd, the idea that we could have a one size fit all portfolio of investments that could fit all is absurd. Each individual is different with different needs, time horizon and risk appetite. Therefore, the portfolio that is well balanced for one individual may not be so for another. Which brings us to the topic of this article. How to create a well-balanced portfolio?

The first thing to do in order to create a well-balanced portfolio is to understand the ‘who’, ‘what’ and ‘when’ of the investments by answering the following 3 questions before we even start creating the portfolio:

• Who is the investor?
  
  This is the first consideration in the journey to creating a portfolio. The risk that a 25-year-old who has just started his career and has no dependents, can take with his investment is generally more than the risk that a 45-year-old with aging parents, spouse and children dependent on him may be able to handle. The risk appetite of a 65-year-old who is dependent on the money from his annuity but still manages to invest some amount of it has to have a much lower risk-taking appetite. Although there is no rule of thumb in this, it's a general understanding that investors who have fewer dependents on them and are at a younger age can take advantage of high-risk investment options like equity. Since this cannot be taken as a rule, we still need to understand the profile of the investor and his unique situation before we can decide on this risk-taking propensity.


• What is the reason for his investment?
  
  The second most important thing to consider while creating a well-balanced investment portfolio is to find out the reason that the individual is investing. This will translate to his financial goals. A person who wants to save for his retirement has a different need than one who is saving up for the down payment of buying his own house. The ‘what’ of investments will also determine the type of investment instruments that can align to the investor’s goals


• When will he need the money from his investment?
  
  Financial goals have certain attached timelines by when they should be achieved. So, a person who is saving for purchasing a car may need the funds faster than one who is saving up for his children’s higher education. This kind of difference is visible in all the financial goals that an investor might have and is the next most important consideration for creation of a well-balanced portfolio suited to the particular investor’s needs.

What is a well-balanced portfolio?

Typically, a well-balanced portfolio has a distribution of debt and equity investments that aligns to the investor’s financial goals, risk appetite and investment horizon. An aggressive portfolio might have a 70/30 ratio between Equity and Debt. A conservative investor may want to reverse the Debt/ Equity ratio to 60/40. Then again, there is no particular formula for this allocation.

The balancing in this portfolio of investments needs to be done as per individual needs and not as per a set down formula that makes it an ideal well-balanced portfolio. The main criteria are to earn high returns, while at the same time protecting the capital from eroding, so that when the funds are required there is no unpleasant surprise in store. The well-balanced portfolio also includes a mix of various asset classes like commodities (including Gold) and Real Estate besides the allocation to Equity and Debt. Let us understand the various asset classes in brief:

1.Equity: This represents a share in the ownership of a company. When you invest in equity, you are actually buying stocks of the company that represents the share. This means that you are buying a small part of the company and can claim a part of the future earnings of the company corresponding to your share. Now, the company that you invest in may be one that features as one of the top 100 companies listed on the Stock Exchange in India (Large Cap), or companies that lie between the 101-250th place (Midcap) or the Small Cap Companies that comprise all those companies that feature beyond the 250 large and Mid-cap stocks. Alternatively, you can invest in various category of equity mutual funds.

2.Debt: This represents a fixed income asset that is a financial contract between two parties - the lender and the borrower. This means that Debt represents a loan whereby the borrower, that is a company, or some Government entity borrows money from the lender, who is the investor by issuing Bonds or Commercial papers. The lender thus earns a fixed income (interest) and gets back the initial amount invested (Principal) at the end of the tenure of the loan. Debt instruments typically carry a lower risk in the short term as the returns on them are dependent on the prevailing interest rate apart from the Credit risk associated with the category of the borrower. In the short term, interest rates are less likely to change. Government bonds are the least risky amongst the debt instruments. To invest in debt products, you can invest in debt mutual funds.

3.Commodities: This represents commodities like Gold, Silver etc. Investing in commodities can give exposure to these commodities and the returns on them. This type of investment carries high risk, and the returns depend on the price of the commodities in the market. Gold and Silver are popular investment options in India that can be bought as an ETF or mutual Funds.

4.Real Estate: When you invest in real estate through funds like REITs you invest in the firms that undertake large projects in the real estate arena. By investing in these funds, you stand to earn returns on your investment. These investments carry risk due to market downturns, policy decisions etc.

How to create a well-balanced portfolio?

Now that you know the different elements that constitute investments, it is now the time to start creating your portfolio. Base your decisions on the investment horizon for the financial goals and your specific risk appetite before embarking on a clearly defined mix of assets that you can invest in to achieve your goals. Long term goals align well to equity investments and shorter-term goals may do well with debt instruments. Your financial advisor or mutual fund distributor can work with you to plan a well-balanced portfolio based on all the elements discussed so far.

Is it necessary to balance your portfolio?

The one-word answer to this question is a loud resounding “Yes”. With the changing age and financial position as well the changing financial needs, the correlation between various elements in your investment portfolio is bound to change. Therefore, you need to re-evaluate your financial goals and the time left to achieve them at regular intervals of about 3-5 years to see if they need any rebalancing.

Conclusion

By taking into consideration all that has been discussed so far you can be assured that your portfolio will be well balanced to your needs. Contact your Eastern Financiers mutual fund advisor who can help you start the journey to achieve your financial goals with a well-balanced portfolio.