If you've made the decision to invest in mutual funds, here's a step-by-step guide to constructing a portfolio that can help you accomplish your financial objectives.
If you're currently reading this article, you're probably interested in investing in mutual funds. Congratulations on making this wise choice. The subsequent step entails determining which funds to invest in, how to go about it, and what factors to consider. This article will address most of your questions. Let's get started.
Step 1: Define Your Objectives
The initial step in building a mutual fund portfolio is to identify the objectives for which you're constructing the portfolio. Establishing clear goals is critical because all subsequent decisions will be guided by them. Investing without a goal is akin to boarding a train without a destination in mind. These goals can be diverse, such as investing for your dream home, planning for your children's education, or saving for retirement.
Goal identification also assists in determining the time horizon, which aids in assessing the level of risk you can tolerate. The longer the horizon, the higher the risk you can assume. Conversely, shorter horizons entail lower risk levels.
Step 2: Choose Investment Options Based on Time Horizon
Once you've identified your goals and their respective time horizons, you can proceed to select the appropriate investment options for each of them. For instance, if you have a short- to medium-term time horizon (one to three years), you can invest a larger portion of your portfolio in debt mutual funds with short to medium durations. Generally, a time horizon of five to seven years is advisable for investing in equity funds. If your horizon is shorter than that, allocating a higher portion of your investments to debt funds or hybrid funds would be more suitable.
If you're unsure which equity mutual funds to choose, you can start with index funds. Unlike active funds, index funds don't aim to outperform their respective indices. Instead, they strive to replicate the performance of their underlying indices. Does this mean you'll have to settle for average returns? Not necessarily. Across various categories, active funds have struggled to outperform their benchmark indices. Therefore, you won't be compromising on returns.
Step 3: Diversify Your Investments
Once you've identified your goals and the suitable asset classes for them, the next step is to diversify your mutual fund investments across the assets/options identified in Step 2.
For instance, let's say you want to save and invest for your child's higher education, with a time horizon of 10–12 years. In this case, it's advisable to invest predominantly in equity but not exclusively in equity. It would still be prudent to include gold and debt components in your portfolio as they can reduce portfolio volatility without significantly impacting total returns. This approach helps you stay invested even during periods of market downturns.
You can decide on the percentage allocation to each asset class based on your risk tolerance. For example, you could allocate 60% to equity, 30% to debt, and 10% to gold.
Furthermore, it's not only important to diversify across different asset classes but also within the same asset class. For example, within your equity portion, you can invest in large-cap, mid-cap, and small-cap funds. Including mid- and small-cap funds can potentially boost your long-term returns.
Step 4: Initiate Systematic Investment Plans (SIPs)
This is the most crucial step. Execution holds greater importance than planning, and many investors, even after completing the previous three steps, delay their investment decisions. One reason for this procrastination is the lack of experience in investing in equity mutual funds and the fear of potential market losses.
The solution to this problem is to start with small investments. As you gain more experience, you can gradually increase your investment amount. Starting is crucial because unless you begin, you'll never become comfortable with equity investments. Moreover, for most investors, SIPs represent the best approach to investing. SIPs not only instil discipline in investment behaviour but also help you average your investment costs over time, thereby minimizing the impact of volatility on returns. Additionally, you can start with small SIPs and gradually raise them as your confidence grows.
Step 5: Regularly Review and Rebalance
The final step is to review and rebalance your portfolio. The frequency of this exercise is up to you, but it's advisable to conduct it at least annually.
During this process, you'll revisit steps 2 and 3, where you identified various asset classes and determined the asset allocation. Over time, certain asset classes may experience significant growth, causing your asset allocation to become imbalanced. Therefore, assessing the situation and rebalancing your portfolio is vital to realign it with your desired asset allocation.
Additionally, while conducting this review, you can assess the performance of active mutual funds in your portfolio. If they have consistently underperformed for two or more years, you can consider switching to better-performing alternatives.
The aforementioned steps serve as a general framework for constructing your own mutual fund portfolio. However, it's important to remember that investing and planning for your goals is not a one-time task. It must be done continuously, and you may need to revisit the steps at different points in time.
Disclaimer: Mutual fund investments are subject to market risks. Read all scheme-related documents carefully before investing.