Your portfolio represents the investments made by you over a period of time. Our introduction to the world of investments is typically through the savings account in the bank next door. From there, the next level of investments is typically in tax saving instruments such as PF, PPF, ELSS or tax saving bonds. Then the next level is an introduction to mutual funds and equities.
For most, the portfolio is built largely in an un-structured manner. Sometimes, we tend to ignore some of the basic concepts which can help us build a better portfolio. Remember, the nitty-gritty behind a successful portfolio lies in understanding of three essential parameters i.e. the risk-return trade off, suitable asset allocation and diversification.
Risk-return trade off
Investing always carries some risk. In other words, risk is an uncertainty of the investment giving the returns, which you expected at the time of investment. Investing in cash, deposits, and liquid investments have virtually no risk but provide low returns. Investing in bonds, debentures, mutual funds (debt) have some risk (though not totally risk free) provide moderate returns. Investing in stocks has risks attached and the returns cannot be ascertained. However, they have historically outperformed all other asset classes over a longer period of time. So it is quite clear that an investor could invest in very safe instruments and thereby reduce the riskiness of his or her portfolio. However, in doing so, he or she would also be giving up some potential return and would also need to save much more to meet the long-term financial goals. This strategy would be appropriate for an investor who planned to use the money for a financial goal in the short-term, i.e., someone who needed to know with some certainty the likely future value of the investment.
On the other hand, an investor could invest money in equities with higher potential return, but this would require taking on more risk. Such investor should have the capacity and capability to tolerate the fluctuations in the value of the investments. An investor with long term financial goals is likely to enjoy a greater return on investment with riskier investments.
Most investors are risk-averse, meaning that they would like to earn higher returns and take as little or no risk. So if you dislike taking risk, please understand that it is natural, but you also need to be aware of the trade off.
Asset Allocation
Asset allocation means dividing your investments in different asset classes like equities, bonds (fixed income) and cash. The proportion of division really defines the character of your portfolio and how it behaves with respect to overall risk and return parameters. The asset allocation is defined by the investment horizon and the risk profile of the investor. It is best to assign a goal to your investment and actually invest for a goal. Thus for a long term goal, one can take higher risk and can invest in equities. A longer term ensures that the final return on investment is not impacted by short term volatilities. Investments meant for a short term goal should be put in fixed income category or in liquid investments. A financial plan that takes into account your life goals helps you defining an ideal asset allocation suitable for you.
The asset allocation also depends on one’s ability and capacity to take risk. Some of us can take higher risk and can be comfortable with fluctuations in investments. Investments are means to your financial goals. If you are not comfortable with the path you choose i.e. the investments you make, it is better to take another path. So the asset allocation somewhere defines the kind of person you are.
Diversification
This specifically concerns the equities that you hold in your portfolio. The best way to describe this principle is through an old adage - “Don’t put all your eggs in one basket”. From there to some technical studies that have been done, it is proven that the best way to invest in the stock markets is to hold a diversified portfolio across companies and across sectors. The market doesn’t really pay for an un-diversified portfolio.
You can invest into equities directly or indirectly through mutual funds or PMS. As the portfolio in mutual funds and PMS is not always known or tracked, one could actually be overly exposing the portfolio to a single stock or a single sector without being aware. Thus, it is necessary to review your portfolio regularly.
The Portfolio Evaluation Services
The Portfolio Evaluation Services puts your portfolio under a microscope and evaluates it on the three parameters mentioned above i.e. risk-return trade-off; suitable asset allocation and diversification. The analysis is done by a team of experts and gives an in-depth and un-biased evaluation on the health of your portfolio.
There are a number of investment techniques to choose from to be a better investor. Here we explain several stock investment techniques with pros and cons of each which may help you know what works best for you depending on your needs and aspirations.
Growth vs. Value vs. GARP strategy
Growth strategy, also known as capital growth strategy, is basically a long term investment strategy that focuses on stocks of companies with excellent track record of earrings growth and great earnings potential in the future. Growth investors look for companies that expect their earnings to increase by a substantial amount - say 20 - 25 per cent annually. These investors do not mind paying a premium for these stocks as they expect growth to sustain in the coming future. Growth strategy generally results high price-to-earnings, price-to-book and low dividend yields.
Growth investing has a potential to deliver higher returns in the long run and also offers tax efficiency as long term capital gains are tax exempt. On the flip side, higher expectations on a company's growth can turn down investor if a company is unable to meet up with expectations. Also, market correction generally affects growth stocks more than others as they often trade at higher valuations. It also demands active investor involvement to pick the stocks that are well poised for growth.
Value investing, on the other hand, puts more weight on valuation measures of a stock. Value investing involves purchasing a stock at a relatively low price, as indicated by low price-to-earnings, price-to-book, and high dividend yields. A value investor looks to buy a stock when it’s undervalued and looks to sell a stock when it’s overvalued. Value investors seek to enjoy returns by buying stocks of companies that are going through period of temporary difficulties, and selling them as and when the company recovers and reaches its fair price. Warren Buffett, world’s most successful investor, is a firm believer of value investing.
This is a good strategy for making consistent profits that generally outperform broader markets and is a lesser risky investment approach. However, getting an intrinsic value or a fair price of a stock is tricky. For instance, two analysts can value a stock and come at different intrinsic values. Also, capital returns of value stocks may be lower than growth investing.
Whereas, growth at a reasonable price (GARP) is the blend of above two strategies of growth and value. GARP investors look for companies that are showing consistent earnings growth (core of growth investing) and that are available at a relatively lower price (core of value investing). A GARP investor can achieve more consistent and predictable returns with a blend of growth and value investing. A GARP investor mainly looks at Price/Earnings to Growth (PEG) ratio (see the formula below). A PEG of 1 means the market considers the stock to be fair value. A PEG under 1 means the stock is undervalued, while a PEG over 1 means the stock is overvalued. The GARP investment strategy was popularized by legendary investor Peter Lynch.
PEG Ratio =
Price-to-earnings (P/E) ratio
Annual EPS growth
GARP investing, having twin benefits of growth and value investing, offers relatively steady returns in all types of market conditions. However, combining growth and value styles is not as easy as it sounds. It requires incredible efforts to choose the stocks with this strategy. Moreover, GARP stocks tend to have higher volatility.
In a nutshell, growth investors enjoy capital appreciation in the long run in form of capital gains; Value investors receive more regular income in the form of dividends; and GARP investors get fairly steady returns across all market conditions.
Momentum vs. Contrarian strategy
Momentum investing is the practice of investing in shares that have considerably outperformed the market in recent periods on the expectations that this momentum will continue. Momentum investors look to buy the stocks whose price is increasing since recent past - say from last 3 to 12 months. These investors prefer to buy high and sell higher. They look at a variety of fundamental and technical indicators while picking up the stocks. Fundamental factors such as consistent earnings surprises, changes in earnings guidance, etc. Technical indicators such as stocks trading their 52-week highs, consistent uptrend in price, etc.
Momentum investing has potential to generate higher returns in the short-term and it's easy to understand method of stock picking. On the drawback side, it is a higher-risk investment strategy, as momentum in stocks/market is not always certain. Moreover, investors cannot make ‘‘above average'' returns consistently.
Contrarian strategy, on the other hand, is opposite of momentum investing. A contrarian investor goes against the herd and picks up the stocks that are out of flavor. When others exit, a contrarian investor enters, and vice a versa. For example: If a stock of company A bottoms out, a normal investor would like to exit, but a contrarian investor will think “what can get worse than this” and may invest. It is not an easy job to be a contrarian investor as it demands massive conviction and belief to go against the herd.
Contrarian investing tends to outperform over the longer-term economic and market cycles and can be extremely rewarding if the bets turn correct. However, it requires patience and deep understanding of companies to be a contrarian. In addition, it is higher-risk tactic.
To summarize, momentum investing works well for intraday / short term traders. A contrarian approach works well for long term investors. By going against the crowd, a contrarian investor can pick up shares of a fundamentally sound company that is currently going through some difficulties, hold it for some time, and sell them when it recovers. However, if you are a risk-averse investor, this may not be best investing approach for you.
Buy and Hold Strategy
Buy and hold is a long-term stock picking strategy based on the view that equity markets give good returns in the long run despite periods of volatility or decline. As timing the market is not possible, it is better to simply buy and hold the stocks for long term and create wealth. This investment strategy is best suitable for new and not so active investors. This is also a strategy that has created long term wealth for investors.
Buy and hold strategy is economical since stocks are not frequently traded. It is also a tax efficient strategy as long term capital gains are tax exempt. More importantly, it offers peace of mind as one need not worry of short-term market fluctuations. However, this strategy may pose a crucial question i.e. how long one should hold the stock. As longer the one waits, smaller the real returns may be due to rising inflation. And, it may not be suitable for every investment need as it is designed to produce long term results only.
Buy and hold strategy is economical since stocks are not frequently traded. It is also a tax efficient strategy as long term capital gains are tax exempt. More importantly, it offers peace of mind as one need not worry of short-term market fluctuations. However, this strategy may pose a crucial question i.e. how long one should hold the stock. As longer the one waits, smaller the real returns may be due to rising inflation. And, it may not be suitable for every investment need as it is designed to produce long term results only.
Fundamental vs. technical analysis
Fundamental analysis is a method of evaluating a stock to measure its intrinsic value, by studying various macroeconomic and company-specific factors. Technical analysis, on the other hand, is a method of evaluating a stock by analyzing statistics generated by market activities, such as price and volume patterns. Technical analysts use charts and other tools to identify patterns that can suggest future activity.
Out of the two, fundamental analysis is a long-term and more disciplined investment strategy. Technical analysis is best suited for traders. However, it is essential to look at both fundamentals as well as chart patterns before investing in a company.
Active vs. Passive Investing
Active investors believe in their ability to outperform the overall market or say a benchmark index. For example, an investor might buy or sell certain stocks to get better returns than its benchmark index. This strategy has potential for generating higher than market returns. But at the same time, it requires expert analyses and ability to react to market conditions.
Active Investing has a potential to generate alpha, but requires expert analysis, time, knowledge and skills to actively manage investments. One can select a variety of stocks and can actively align investments to achieve goals with this strategy. But it could also result into higher transaction costs. It is also a less tax efficient strategy as frequent trading may result is short-term capital gains tax.
Active Investing has a potential to generate alpha, but requires expert analysis, time, knowledge and skills to actively manage investments. One can select a variety of stocks and can actively align investments to achieve goals with this strategy. But it could also result into higher transaction costs. It is also a less tax efficient strategy as frequent trading may result is short-term capital gains tax.
It is generally a low-cost and tax efficient strategy and has reduced uncertainty of errors in investment decisions. However, one has limited control and choice over passive investments.
To sum up, active investing can generate alpha, but requires high amount of time and energy to actively manage portfolios. It is mainly suitable for investors who can take some risk and have required amount of time, energy, skills and knowledge. Passive investing is well suited to investors who are risk-averse and do not have sufficient time and skills to actively manage their portfolios.
To conclude, it is your personal approach to investments that matter the most. Just make sure that your investment strategy is directed towards achieving your long term goals and help you create wealth.
One thing you might have eventually learned that no one can have control over markets. What you can control is your investment strategy - having the framework in place to improve your chance of meeting goals. All it requires is deliberate planning based on your personal financial profile. With the right groundwork and guidance, you can lay a strong foundation for building an optimal investment portfolio (achieving the best possible trade-off between risk and return). Here we walk you through every step that is essential for building a portfolio. Read on to discover those steps...
Plan your investment strategy - Before investing, it is important that you devote some time to plan your investment strategy. This can really make the difference between achieving your goals and simply aspiring for them. Having a clear idea of your goals, timeline to achieve them and knowing your risk profile provides a solid base on which a portfolio can be built.
Ask yourself, what you want from your portfolio. For example, if you are dependent on the income flow from an investment, the portfolio needs to be built to meet this objective. However if you have a long term growth objective from your portfolio it needs to be designed for growth and capital appreciation. Investment objectives can be part growth and part income. And because no single investment can meet both, you may balance the same in the portfolio.
A cautious investment strategy helps you get more favorable long-term results than the one without forethought.
Get your asset allocation right - A portfolio should be built around your needs, which in turn depend on your income, age, and ability to take risk. To best achieve your goals, you need to get your asset allocation right. Asset allocation involves a decision on how to divide your portfolio among different types of assets classes.
There are two major types of assets: Income-oriented and growth-oriented. Growth-oriented investments primarily provide returns in the form of capital appreciation, e.g. equities. Over the longer run these investments provide good real returns (nominal returns –inflation rate). Some equities also provide income in the form of dividends. Income-oriented investments, on the other hand, primarily provide returns in the form of income, e.g. bonds. These instruments tend to provide more stable, albeit lower returns over the long term.
Your needs should determine which investments to choose. For instance, a retired person will probably choose a lower-risk, income-oriented approach for stable income. In contrast, a high-income, financially secure individual may be willing to take more risks in hopes of earning high returns. Similarly, a young investor with a good job may not be much concerned about regular income from investments and may be more able to take risks.
The idea is to position your portfolio in such a way that it takes the advantage of both negative and positive developments in the market.
Each asset class performs differently over the timeframe, hence the diversification is essential. The table below shows the year-on-year calendar returns by major asset classes, illustrating the importance of holding a diversified portfolio:
As you can see in the above table, different asset class takes the top performance spot every year. It is difficult, even for experts, to accurately predict the exact course or return of an investment. Thus, it is best to hold a diversified portfolio consisting of all the major asset classes based on your needs and risk profile. Here’s the performance of major asset classes.
CAGR returns delivered by major asset classes over the past 5, 7, and 10 years:
| Major Asset Classes |
5-year returns |
7-year returns |
10-year returns |
|
Indian Equities (Benchmark: BSE SENSEX)
|
-1.4 %
|
13.3 %
|
20.3 %
|
|
International Equities (MSCI World)
|
-5.0 %
|
-1.0 %
|
5 %
|
|
Bonds (CRISIL Composite Bond Fund Index)
|
6.7 %
|
6.2 %
|
5.9 %
|
|
G-Sec (I-Sec Composite Gilt Index)
|
8.1 %
|
7.6 %
|
6.8 %
|
|
Gold (INR) (MCX GOLD SPOT)
|
25 %
|
23.6 %
|
N.A.
|
|
Gold ($) (International Gold)
|
17 %
|
21 %
|
18 %
|
|
Cash/cash equivalents (CRISIL Liquid Fund Index)
|
7 %
|
6.1 %
|
6.9 %
|
(Data as on 31st October, 2012; source: ACE MF and Bloomberg; N.A. – Data available from 2005)
Generally, the longer you stay invested, the better. Growth assets like equities generate higher returns over the long run. For instance, even if you would have invested ₹1,000 in domestic equities, 7 years ago, today it would have become ₹13,900. Likewise, ₹1,000 invested in bonds would have become ₹5,220; and ₹6,660 if invested in government securities (G-Secs). Whereas, ₹1,000 invested in gold 7 would have become ₹34,200! (See the graph below):
Today’s value of ₹1,000 invested 7 years ago in major asset classes (To 31st October 2012)
Review your portfolio regularly
You should check your portfolio regularly for two reasons: First, to make sure that your portfolio is in line with original asset mix; and second, to see if the asset allocation is still appropriate for your goals.
Here are some of the reasons to review your portfolio regularly :
- A major change in personal circumstances - marriage, birth of a child, child graduating from college, etc. – that changes your investment goals
- The proportion of an asset rises or falls considerably and thereby changes your target allocation for that class by more than, say 5% or so
- When you get closer to reaching a certain goal (e.g. as you near retirement age it is wise to hold less stocks and more bonds and cash equivalents to reduce the risk of volatility)
Rebalance your portfolio - Periodically, you may find it necessary to rebalance your portfolio- that is, to reallocate the assets in your portfolio. One approach is to rebalance your portfolio at regular time intervals, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing.
Another approach to rebalancing is only when the relative weight of an asset class increases or decreases more than a certain percentage that you have identified in advance. For example, suppose that your asset allocation plan calls for 70% equities but then the stock market falls and so stocks represent only 55% of your total portfolio value. Then you may add stocks and bring your portfolio back up to 75% in equities. The advantage of this method is that your investments tell you when to rebalance.
But don’t be too quick to rebalance every time your portfolio rises or falls in value. Rebalancing tends to work best when done on a relatively infrequent basis. Re Balancing once a year or based on any major change is advisable. It is always in your interest to make changes to your portfolio under the guidance of a financial expert.
Keep the track of your investments - You must keep a tab on your investments as in how they have performed over a period, and whether they have lived up to your expectations. Sometimes investments may not perform the way you thought they would. In any case, it may be time to sell and put the money somewhere else. A monitoring system should help you identify such instances. Knowing when to sell and when to hold can significantly affect the amount of return you are able to generate from your investments.
To sum up, we hope these steps will help you build an optimal portfolio on a strong foundation.