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A perfect mutual fund portfolio is one that is commensurate with ones appetite for risk and is capable of meeting ones financial goals.
An investor in the equity markets, especially through the mutual fund route, has to acknowledge that volatility is part and parcel of the markets. The focus should, therefore, be on learning how to navigate volatile markets so that one does not get off-tracked from his/her investment thesis during periods of heightened volatility -- as is happening now.
The first step towards creating a mutual fund portfolio is the identification of one's tolerance for risk as this drives the decision-making process pertaining to asset allocation and the quantum of allocation in each asset class. Once one has accurately identified individual risk tolerance, the next step is to identify financial goals; ideally, these should be clearly categorised into short-term, medium-term and long-term objectives.
The smartest way to create a goal-based portfolio is to allocate a separate portfolio for each financial goal or club similar goals based on risk profile and duration and create a common portfolio. One can club retirement and child's higher education in one portfolio and buying a car or a future foreign trip in another portfolio.
Asset allocation strategies are dependent on the time-horizon of the financial goal. To realise short-term goals one need's predictable cash flows and therefore, a higher component of debt instruments is necessary.
For medium-term goals the portfolio should have a healthy mix of both equity and debt and for longer-term goals the portfolio should have a higher component of equity to be able to beat inflation.
After one has zeroed in on the asset allocation for all the goals, the next step is to pick the right kind of mutual fund category that is capable of meeting a particular financial goal.
Once the required mutual fund categories have been identified, the next step is to choose the right schemes within a particular category. The selection criterion should hinge on the investment objective and consistency of returns that a mutual fund has been able to deliver.
Efforts should be made to pick funds with larger assets under management and reputed brand names with a better track record of delivery. Total expense ratio is another important criterion: A fund with lower expense ratio is always better than funds with a higher expense ratio, other things being the same.
Based on one's financial goals he/she would need to invest in both equity and debt mutual funds and would also have to pick several mutual fund schemes. However, it should be remembered that finalising the portfolio with too many funds is a bad idea as beyond a certain limit -- for example, a maximum six to eight schemes; there is no benefit of over-diversifying. Over-diversification leads to lower returns and monitoring and re-balancing becomes tedious for an investor.
Finally, building a perfect portfolio is always based on suitable asset allocation that is derived from one's risk appetite and investment horizon. The perfect way of investment over the long term is continuous asset allocation focused on goal-based portfolio creation. Each goal should be precise, defined in quantitative terms and duration.
(Rahul Agarwal is Director, Wealth Discovery/EZ Wealth advisory. The views expessed are personal. He can be reached at firstname.lastname@example.org )