Let us begin by defining performance. Before we try to make our portfolio perform better, the primary goals should be to define performance. Obviously, performance cannot be defined in terms of returns alone. It has to be returns on a risk-adjusted basis. Secondly, all portfolio performance has to be with respect to goals. The biggest metrics is that the goals are achieved and that is what performance is all about. Lastly, performance of your portfolio is also about making the best of the broader trend shifts in the market. Let us understand how to build an investment portfolio for beginners. We use a stock portfolio example to see how to build a profitable portfolio. Here are 6 steps to make your portfolio perform better in the market..
1. Create the portfolio with your goals in mind
That is where you portfolio creation starts and this plays a crucial role in how your portfolio eventually performs. The best way to create a portfolio that performs better is to build it around your goals. That should serve as the rationale for your portfolio. For example, if you have a goal that matures in 3-5 years, you cannot be too heavy on equities. It will have to be a debt fund or, at best, a balanced fund. If your goals are for the longer haul, then you need to be predominantly invested in equities. Otherwise, you will end up with sub-optimal portfolio allocation. As long as your portfolio is closely aligned with your goals, it is likely to do better than the market; from your perspective.
2. The biggest risk is not taking any risk
There are different interpretations to this statement. What it essentially means is that where risk is due you need to take on risk. Therefore, when you look at long term goals you need to be predominantly invested in equities. That is because; over the longer term equities tend to outperform all other asset classes by a margin. This outperformance comes with very minimal downside risks as the time frame keeps expanding. The second approach to this issue is should your equity exposure go down with age. That is not entirely true. Compare a 35 year old professional with a lot of liabilities against a 40 year old man who has discharged all his liabilities. Obviously, the 40-year old man has a bigger risk appetite and should have a higher exposure to equities. For the 40-year man the biggest risk is not taking risk.
3. You need liquidity, but not too much of it
You need to have liquidity and that should be designed to meet emergencies. Why do you need liquidity in the first place? There are 2 occasions you require liquidity. Firstly, you need to keep an emergency fund of 5-6 months of your income for any exigency. Once that is done, don’t just keep on building it. Secondly, you need liquidity around milestones like child’s education, child’s marriage, home loan margin etc. You can shift to liquid assets a few months ahead of the milestone date to reduce your risk. Otherwise, don’t overexpose yourself to liquidity beyond a point.
4. Focus on a passive rule-based approach
The best way to outperform over the longer run is to adopt a rule-based approach. For example, when the P/E of the Nifty is below 14, you will be 70% invested in equities. When the P/E of the Nifty is above 24, you will reduce your equity exposure to 30%. You can apply similar rule based approaches to gold and debt based on past data. The advantage of this rule-based approach is that it involves minimum subjectivity and human discretion. Since it is based on calibrated past data, the probability of being right is very high.
5. Keep rebalancing your portfolio at regular intervals
Portfolio rebalancing is partially an extension of the point on rule-based approach. When should you rebalance your portfolio? Remember, a long term portfolio must not be subjected to continuous rebalancing. Ideally, the portfolio should be reviewed once a year but rebalancing should only be down once in 3-4 years. Remember, rebalancing has a cost in terms of transaction charges and taxes. Hence, rebalancing should be done only when it is perfectly justified and is likely to be value accretive. Rebalancing can also be triggered when macros move to extremes. For example Nifty P/E at 27, Nifty P/E at 10, Dividend Yields at 0.5%, bond yields at 20-year highs, bond yields at 20-year lows; are all classic triggers for rebalancing your portfolio.
6. Always plan your portfolio in post-tax terms
Planning your portfolio in post-tax terms not only helps you outperform the market but also avoids nasty surprises with respect to goals. For example, when you do an equity fund SIP over 20 years, then 80-85% of the corpus will be in the form of capital gains which will attract 10% flat capital gains tax. Effectively, if you plan a corpus of Rs.1 crore after 20 years then you will get Rs.92 lakhs in post tax terms. When you plan your portfolio in post tax terms, you have the option of either increasing the SIP amount or the risk so as to reach your goals in post-tax terms.
Stick to the basics, and you are very likely to have an outperforming portfolio in your hands!