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Session 18: Model Portfolios based on Risk Appetite and Time Horizon



We are glad to have you with us for our Eighteenth Session - Model Portfolios based on Risk Appetite and Time Horizon.

Alright so now let's get started with our learning session today and see how you should build an optimal mutual fund portfolio based on your risk appetite and time horizon.

In our previous lecture, we told you how to select winning mutual funds. Once you have done so, the next step would be to build an optimal mutual fund portfolio that can help you achieve your investment objective over a longer time period. But identifying right funds and building a mutual fund portfolio may not be a simple task. With over thousands of mutual funds available today, the task can become herculean and complex, as there may be funds that may not be doing what they say, and hence may not be suitable for your portfolio. So you need to be careful.

In today's session we will tell you about how to go about building a mutual fund portfolio. And more importantly we will tell you about how to structure a mutual fund portfolio based on your risk appetite and time horizon.

So let us first understand the...


Process of Building a Mutual Fund Portfolio

While there is no standard rule to this, we can broadly divide the process of building a mutual fund portfolio into two steps. The first step involves eliminating mutual fund schemes and the second step involves selecting mutual fund schemes for the portfolio.

  • Process of elimination (...As you need to be cautious while picking mutual funds for your portfolio, the process of elimination is important while building your portfolio. You should clearly know what kind of mutual fund schemes may suit you. So that you can have the right funds in your portfolio and know what kind of funds you should avoid. Moreover, you should question the existence of every mutual fund in your portfolio, so that you are left only with the funds that suit your profile. Now while eliminating mutual funds, one has to keep in mind the following points...

    • Define your filtration criteria: (...Filtration plays an important role while selecting funds for your portfolio. As you may be looking for funds that have shown a consistent track record in the long run, you may not like to add funds that have no track record or less track records to show. Hence you can have an initial criterion like, funds that have not completed a 3-Yr track record. With this you will be automatically left with those that have at least a 3-Yr track record.)

    • (You should clearly define and...) Refrain from investing in schemes not suitable for you (...If you have a low risk appetite, then you can refrain from investing in sector/thematic mutual funds, as such schemes have a tendency to plunge more during the downturn. It is best to opt for mutual fund schemes with a broad investment mandate, championed by well-diversified equity funds. Eliminating all sector/thematic funds, would leave you with just the well-diversified ones.)

    • Limit the number of funds in your portfolio: (...It's important for you to guard yourself against over-diversification. Hence you should limit the number of funds in your portfolio. Do not forget, your fund manager is already taking care of diversification and hence there is little point in diversifying something that is already diversified.)

    • Avoid duplication: (...If there are two or more mutual funds that seem to be doing the same thing in terms of mandate or style, then you have to ensure that you are left with just the best in that category and eliminate the rest. Do a peer comparison.)

    • Eliminate inconsistent performers: (...Finally, evaluate fund's performance over a long-term (say 3-5 years) and over various market cycles. This will enable you to understand whether the equity fund under review has stood the test of time. Many momentum funds may do reasonably well during a swift market rally in the short term, leading investors to believe they are well-managed funds. But do not forget, if the markets had not appreciated sharply, the fund may have been one of the dismal performers over this period. It takes a bear phase to separate the men from the boys. Eliminating such funds may help you shortlist consistent performers.)

  • Process of selection - (...Once the elimination process is performed by the investors diligently enough, the second step will come naturally. For instance, if you have ignored all the sector/thematic funds, that leaves you with just the well-diversified ones. Likewise, if you eliminate all funds that have not completed a 3-Yr track record, you are automatically left with those that have a minimum 3-Yr track record. So while selecting mutual funds for your portfolio, you must keep the following points in mind...)

    • Select across market caps: (...Investors should have a mix of both large cap as well as mid cap funds, since both have their inherent strengths. When both are well-selected, they can reward the investor handsomely over the long-term. The proportion of investments in large cap funds will depend upon the risk appetite of the investor. For example, a 25-year old person would have a higher allocation towards mid cap funds, when compared to large cap funds. Similarly, it also pays to invest in an equity fund that can invest in both large caps and mid caps depending on the opportunity; these funds are commonly referred to as opportunities or flexi cap funds.)

    • Select across investment style: (...Investors should go for both - well-managed growth style and value style equity funds. This will help capitalise on opportunities across the board. Growth funds invest in well-managed companies that are likely to show high growth going forward. Whereas, value style funds invest in well-managed companies that are undervalued temporarily, but have the potential to achieve their fair value in the future.)

    • Select across asset class: (...Investing in a mix of equity and debt or a hybrid fund can help bring in stability to the portfolio on account of the provision in the investment mandate for investment in debt. But while deciding on the allocation between equity and debt, it is vital to judge your risk appetite, and follow a prudent approach.)

      To top it all, your selection process must purely be based on research and analysis. Your agent, neighbours and colleagues are welcome to air their views, but remember at the end of the day it's your own hard earned money.

Once you are aware about the process of picking mutual funds to build a portfolio, the next step would be building an ideal mutual fund portfolio that can meet your investment objectives.

So let's see what can be different...


Approaches to Building a Mutual Fund Portfolio

  • Building Portfolio based on Risk Appetite (...Defining your risk appetite plays an integral role in building an ideal mutual funds' portfolio. You can define your risk appetite as ...)

    • Aggressive Risk Appetite (...Investors who have a penchant for making high returns by taking high risk can be termed as aggressive. Such investors can include high growth funds in their portfolio that can generate high returns in the future.)

    • (Investors with...) Moderate Risk Appetite (...may look for decent return, but at the same time would not like to take high risk. Such investors need to balance their portfolio well between growth and stability.)

    • Conservative Risk Appetite (...Some investors may not like to take risk with their money and hence prefer stability over growth. If you have a conservative risk appetite, then you should look for stable funds that have the ability to limit downside risk during uncertain market conditions.)

    % of portfolio based on Risk Appetite
    Market Cap / Style Aggressive Moderate Conservative
    Large-cap Funds 20% 30% 40%
    Mid-cap Funds 30% 10% -
    Multi-cap Funds 10% 20% 20%
    Flexi-caps / Opportunities 30% 20% -
    Balanced Funds - 20% 40%
    Sector / Thematic Funds 10% - -
    Portfolio Total 100% 100% 100%
    The above table is indicative and for illustration purpose only
    (Source: PersonalFN Research)

    The table here shows how you can allocate your portfolio to various categories of mutual funds based on your risk appetite. So while an aggressive investor can have high exposure to mid-caps and such high growth funds, a conservative investor should have high exposure to large caps and balanced kind of funds that are known to be more stable. And as you can see a Moderate risk investor can have a mix of aggressive and stable funds in his portfolio. Based on your risk appetite, you should define an allocation to various categories of mutual funds that may be suitable for you and then pick the best funds based on your parameters under each category for your portfolio.

  • Building Portfolio based on Strategy (...You can optimise your portfolio by having a proper strategy. You should clearly know the purpose of each holding in your portfolio. So accordingly you can classify the components of your portfolio into...)

    • Core Holdings (...The key and stable holdings in your portfolio that you intend to preserve in your portfolio irrespective of market conditions are your core holdings. The core holdings in your portfolio can help you steadily grow your wealth in the long run and may help you meet your extreme long term goals.)

    • (While the...) Satellite Holdings (...in your portfolio are like toppings that can add a flavour of extra-ordinary returns to your portfolio. These can be high risk-high return kind of funds that you may add to your portfolio for additional returns. But while doing so, you need to be ready to bear the excess volatility that it may bring to your portfolio. Moreover you may need to keep a close track of such holdings and take timely measures during unfavourable conditions.)

      % of portfolio based on Strategy - Risk wise
      Market Cap / Style Aggressive Moderate Conservative
      Core 50% 60% 80%
      Large-cap Funds 20% 30% 40%
      Mid-cap Funds 20% - -
      Multi-cap Funds 10% 20% 10%
      Balanced Funds - 10% 30%
      Satellite 50% 40% 20%
      Mid-cap Funds 10% 10% -
      Multi-cap Funds - - 10%
      Flexi-caps / Opportunities 30% 20% -
      Balanced Funds - 10% 10%
      Sector / Thematic Funds 10% - -
      Portfolio Total 100% 100% 100%
      The above table is indicative and for illustration purpose only
      (Source: PersonalFN Research)

      The portfolio table shown here is an example of a Strategic portfolio. You see, the proportion of core and satellite holdings in your portfolio may vary based on your risk appetite. So a conservative investor would prefer stability over growth and hence would hold more of core holdings as they bring stability to the portfolio while having a low penchant for extra-ordinary returns. On the other hand an aggressive investor would be ready to take high risk for high growth and maintain a relatively high exposure to satellite holdings that can bring him extra-ordinary gains. And as we said earlier, investors with moderate risk appetite would maintain a decent balance between stability and growth as per their risk tolerance.

  • Building Portfolio based on Asset Allocation (...Diversification is key to the success of an investment portfolio. You should have proper diversification across asset class.)

    • (Based on your risk appetite you need to...) Define a Standard Allocation across asset class (i.e. equity, debt and gold) (...While aggressive investors may have high allocation towards equities, a conservative investor should prefer relatively higher diversification to other asset class, mainly debt investments that can help maintain stability to the portfolio. Do not forget, you may need to review and change your standard allocation as you progress in your age and nearness to financial goals.)

    • (Moreover, you need to...) Regularly monitor and keep a proper track of your allocation (...As your allocation to each asset class may vary over a period of time. You should review the allocation of your portfolio every 6 to 12 months, especially if there is a swift rally in any of the asset class. This will help keep your portfolio under control and you can take timely measures.)

    • Timely Rebalance your Asset Allocation (...Moreover you need to make sure that the allocation to each asset class in your portfolio is not deviating from the standard allocation you have set for your portfolio. And if it does, then you need to timely rebalance your asset allocation. So if your allocation to equity, debt and gold has moved from your standard allocation of 60:20:20 to 70:15:15, then you can book the additional 10% growth in equities and shift it to debt and gold, in order for the allocation to once again reach 60:20:20)

    % of portfolio based on Asset Allocation - Risk wise
    Market Cap / Style Aggressive Moderate Conservative
    Equity 80% 60% 30%
    Large-cap Funds 20% 30% 40%
    Mid-cap Funds 30% 10% -
    Multi-cap Funds 10% 20% 20%
    Flexi-caps / Opportunities 30% 20% -
    Balanced Funds - 20% 40%
    Sector / Thematic Funds 10% - -
    Debt 10% 25% 50%
    Long Term Income Funds 40% 30% 20%
    Short Term Income Funds 40% 40% 40%
    Money Market / Liquid Funds 20% 30% 40%
    Gold ETFs / Funds 10% 15% 20%
    Portfolio Total 100% 100% 100%
    The above table is indicative and for illustration purpose only
    (Source: PersonalFN Research)

    The table here shows how a mutual fund portfolio can be structured based on asset allocation. As you can see, the portfolio is spread across equity, debt and gold based on one's risk appetite. So if you are an aggressive investor, you may consider equity as a catalyst for wealth creation whereby you hold 80% allocation in equity, and just 10% allocation each for debt and gold. On the other hand, if you are a moderate and / or a conservative investor, you would prefer a higher level of stability. So in such a case you may hold lower exposure to equity and high exposure towards debt and gold. So the allocation for moderate and conservative investors can be 65:25:15 and 30:50:20 respectively across equity, debt and gold. Further, under each asset class you can define the allocation to various styles and categories of mutual funds that can cater to your investment needs.

  • Building Portfolio based on Time Horizon (...Considering your time horizon is a must while building your portfolio. You cannot put your money in risky assets if you need it in the next 3 to 6 months or even 12 months. You should ideally reduce your allocation to risky assets if you are nearing your goal and / or have low time horizon.)

    • (So accordingly if you have...) Short time horizon - (...you need to have...) High exposure to a low risk asset class

    • (On the other hand if you have...) Medium Time Horizon - (...you can have...) Balanced exposure across asset class

    • (Besides, if you have...) Long time horizon - (...You can have...) High exposure to risky asset class

    % of portfolio based on Time Horizon
    Market Cap / Style Less than 3 Mths 3 to 12 Mths 1 Yr to 3 Yrs Above 3 Yrs
    Equity 0% 0% 0% to 10% 80%
    Equity Mutual Funds - - Allocate across category based on your risk appetite
    Debt 100% 100% 80% to 100% 0% to 20%
    Long Term Income Funds - - 50% 60%
    Short Term Income Funds - 50% 50% 40%
    Money Market / Liquid Funds 100% 50% - -
    Gold ETFs / Funds 0% 0% 0% to 10% 10% to 20%
    Portfolio Total 100% 100% 100% 100%
    The above table is indicative and for illustration purpose only
    (Source: PersonalFN Research)

    As you can see in the table - investors having a shorter time horizon, i.e. less than 12 months should hold no exposure to equity and gold, while the entire exposure can be in fixed income assets. But you need to be careful, not all income funds are safe and so you need to be selective. And investors who have medium to longer investment time horizon can increase their exposure towards equities and risky asset class, with some exposure towards gold. So once you have defined your investment time horizon, you can allocate your portfolio to the right category of mutual funds.

Key Takeaway Points!

  • (You should...) Follow a proper elimination and filtration process while building your mutual fund portfolio

  • (You should...) Limit the number of funds in your portfolio

  • (Make sure that you...) Spread your portfolio across investment styles and market caps (...according to your risk appetite)

  • (So...) Build your portfolio based on your risk appetite

  • As an aggressive investor you can look for high growth funds

  • As a conservative investor you would prefer stability and should hold stable funds (...in your portfolio)

  • (While...) As an investor with Moderate risk appetite you should maintain a fair balance between growth and stability

  • (You should...) Define a standard allocation across asset class and timely rebalance your portfolio (...if it deviates from your standard allocation)

  • (Moreover...) Your time horizon is a must while building your portfolio

So to end our learning exercise today, we now invite you to test your learning by taking up this simple quiz (and win exciting prizes!)

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Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.


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