One of the most intriguing questions an investor faces while starting in the stock market is how to build a sound portfolio that produces higher returns with low variations and risk. Usually, an investor demands a return that is slightly in premium to traditional options such as banks and bonds. Obtaining the correct mix of all financial products holds the key to a portfolio that can ride through the market cycles. With this concept in mind, we try to present investors the various components of an ideal portfolio and how they should be selected to get returns during different market cycles.
It is highly recommended that a retail client make a portfolio with a long term perspective. Studies have indicated that retail investors with a short term perspective and higher portfolio churn tend to underperform the broader markets. Hence with a focus on lower churn, a portfolio’s components must be arranged in a tactical way that can consistently provide returns to an investor without a significant drawdown. Hence we divide the whole portfolio into four components that can help the investor allocate capital and diversify risk:
- Bonds- Bonds are an essential part of any portfolio. They provide the necessary fixed return and drive the risk of the portfolio considerably down. The prices of the bond are inversely related to interest rates. Hence in a falling interest rate scenario, bond prices are likely to go up, thereby reducing the yield on the bonds. As per the current low-interest-rate situation, bond prices are expected to go up, making bonds a valuable part in one’s portfolio. However, the yields on those instruments will likely be lower in the coming quarters. While selecting the bonds, it is recommended that an investor invests in quality bonds with higher credit ratings or sovereign bonds. Bonds are meant to create a safety net in the portfolio. Hence, a conservative investing approach is recommended with a stable expected return in line with the yield expected from bank FD’s. Depending on their risk profile and growth aspirations for the portfolio, an allocation of 10-20% is recommended to create a balance in the portfolio.
- Gold: In our previous articles, we had discussed the importance of investing in gold and the favorable returns that were provided by it in the last two decades. This makes gold an almost indispensable part of any portfolio. Although there are no cash inflows from physical gold, modern instruments like sovereign bonds provide an additional coupon rate on returns of gold to give investors absolute returns over a longer time frame. At any point in history, an investment in gold has given returns to the holder. Due to this viewpoint, I highly recommend that out of their dispensable investing income, the investor allocates almost 10% every month to gold. The recent bull run in gold prices is a testimony to the fact that gold has and will continue to generate returns for holders consistently. Based on the risk framework and time frame of an individual, allocating almost 20-30% towards gold is a smart choice for an investor as it will act as a natural hedge against crisis period, preventing significant drawdowns in one’s portfolio.
- Index Funds- Now, we are slowly moving towards the tricky and most rewarding aspect of the portfolio, i.e., allocation towards the equity aspect. Equities are associated with volatility and high returns. Yet there is undisputed evidence that equities as an asset class have outperformed all the other asset classes in the past 50 years. To the retail investor, one of the safest ways to invest is via index funds, which track a particular index like Nifty 50 or the Nasdaq. These funds have low management fees and provide returns in lieu of the index they are following. Investors can buy a particular portion of the index fund and reap in high profits from the stock index without paying any management fees and taking minimal risk in the equities space. A lot of companies like HDFC AMC and other asset management companies provide funds that closely track the index. An allocation of 15-20% is recommended for the investor.
- Direct Equity- Direct investment in equities is a lucrative way to make returns in your portfolio. Any investor who wants to make direct equity a source of investment must follow the philosophy of “consistent compounding.” This philosophy is a low-risk strategy in which an investor scans the stock universe for companies that are generating Returns on Capital Employed (ROCE) well above their cost of capital and post double-digit revenue growth from past 7-8 years. The retail investor needs to buy such companies for a considerable period to get a 15-20% CAGR for their investments.
An investor can also make money in direct equities by betting on the market leaders in a particular segment. As the markets in a developing economy mature, there is a consolidation in the whole industry as the market leaders gain market share due to their superior reach and well positioning of balance sheets to ride through the crisis, thus elevating their bottom line and market value. This strategy ensures that the investor grows his capital consistently at low risk creating massive value in the portfolio. Due to highly varying risk measures, the investor is free to choose the amount of money to be allocated to direct equity.
Here are some of the tips to get started with your portfolio:
- Always invest the money that you don’t need. Make sure you have an ample reserve for your yearly expenditures so that you are not tempted to cash in on your portfolio.
- Bet on Consumption stories. In India, betting on consumption is one of the easiest ways to make money. Consumption is bound to increase due to the growing population and rising income levels. Look for companies that sell products of necessity to millions of Indians. Over a more extended period, these are the companies that will make money.
- NEVER have leverage in your portfolio. Markets are volatile, and sudden dramatic swings can create unfavorable situations in case you are leveraged, thus making you lose what could be multi-bagger investments.
- Give time to your portfolio. Make sure you spend some time during the week analyzing it to look for profitable opportunities. Also, allow your investments to mature over periods to benefit from compounding.
Now you are ready to begin your portfolio. With these tips, I do not doubt that you will be able to generate wealth and create multibagger investments consistently.