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Build a smart investment portfolio in four steps

Investors have different options to invest their money and every option comes with its risks and rewards. While investing in equity is a high risk, high return proposition, investing in debt provides assurance of returns but gains are modest. Real estate is a good long-term investment but ridden with uncertainty in the short term.

Equity, debt, real estate, gold, commodities are different asset classes and perhaps every investor faces the dilemma of how much should be invested in what asset class. The decision to exit from a particular investment or book profits or losses is equally important but often, it's a difficult call to make.

So how does one decide which are the right financial products to invest in and in what proportion should they be held in the overall portfolio?

Asset allocation provides answers to all these perplexing questions. Asset allocation refers to how you allocate the money available to invest, to different asset classes. The goal of asset allocation is to try and create an efficient mix of investments that have the potential to appreciate while meeting your tolerance for risk, your goals and preferences for certain types of investments within an asset class.

The biggest advantage of asset allocation is diversification. Since different assets tend to perform differently under similar market conditions, diversification helps in reducing the risk.

Here are some points to be kept in mind while determining your asset allocation strategy for building a portfolio:

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The author is co-founder and director, Perfios software Solutions Pvt. Ltd.  Perfios (www.perfios.com) offers an online Personal Finance Software Solution that provides a 360 degree view of one's Personal Finance with very little manual effort.

1. Plan your financial goals

Investment can be meaningless without attaching a goal to it. Unless you know what you need the money for, when you need it and how much you need, you cannot plan your investments. For an average investor there are different medium to long-term goals such as buying a property, retirement, children education and the like. If you have the goal in mind, it becomes easier to devise an investment strategy.

2. Allocate based on goals and risk tolerance

Once the goals are determined, it is important to assess how much risk you are willing to take. For example, if someone requires a 15 per cent return from investments in order to achieve a goal, perhaps equity may be the best option.

But if the person has a low risk appetite, equity may not be a suitable option and he may have to modify the goal or postpone it such that he can achieve the goal by investing in low risk instruments. Hence, asset allocation decision is dependent on financial goals, risk appetite, return expectation, time-horizon, liquidity, age as well as life stage of a person.

One may choose to use the services of a financial planner for this purpose.

3. Selection of right products for every asset class

Once the overall asset allocation is decided, you need to pick the right investment products under each class.

Equity

Allocation to equity can be in form of holding stocks or equity mutual funds or ULIPs with an equity option. Investing in equity is high risk but it perhaps the only asset class which can give returns well ahead of inflation when held over long term.

Debt

Investment in fixed income products which provide an assured return would qualify for the debt asset class. For example, bank or company fixed deposits, PPF, post office schemes etc. One can also look at debt mutual funds or ULIPs with debt option.

Although returns from debt may not be as attractive as equity, it provides some stability to the portfolio.

Gold

Gold acts as a hedge against inflation and brings stability to the portfolio. 5 to 10 per cent of the overall portfolio can be allocated to gold. Gold can be held in non-physical form such as Gold ETF or in the physical form such as gold bars or coins. Jewellery held for consumption purposes will not qualify as investment in gold.

Real estate

Real estate investment can be in the form of land, house property or commercial property. This is an asset class which has the potential to appreciate in value as well as provide a regular source of income such as rent. It is relatively illiquid in nature.

Alternative assets

For the high net worth segment, investment in art, international equities, private equity, structured products etc. is gaining significance.

4. Review investment portfolio periodically

On completion of the asset allocation exercise, it is important to conduct a periodical review to ascertain whether rebalancing may be required. For example, if a person has made a 60 per cent allocation to equity and 40 per cent to debt, when the stock markets rise, the balance may tilt in favour of equity.

This indicates that you must book profits in equity and invest in debt to restore the original asset allocation. You may decide at what percentage change you would rebalance the portfolio. Usually a 10 per cent change in asset allocation is good enough to undertake rebalancing exercise.

There are software's designed to build investment portfolios with the right asset allocation but they cannot be relied on completely. Building the right investment portfolio is more an art than a science and there is no standard solution that fits all. It mainly depends on personal variables such as age, risk profile and future goals coupled with frequent evaluation of portfolio.