Simplicity trumps complexity in investing

Everything in life involves a choice, even the simplest of things: bread and butter or cornflakes for breakfast? Drive or take a cab to the office? Investment decisions are no different. Given the plethora of choices available, how do you build an investment portfolio for your long-term financial goals that minimises regret over choices? The best thing to do is to follow an approach that is easy to understand, adhere to, and execute.

Let me share an investment process that involves just three steps: Decide target asset allocation for your portfolio; decide sub-allocation within a particular asset and choose products; review and rebalance regularly.

Asset allocation refers to how much to allocate to various assets such as stocks, fixed income and gold. Your target asset allocation should be determined by your risk appetite and financial goals. An aggressive investor planning for long-term goals can take a higher exposure to risky assets such as stocks and gold, and vice versa.  

Next, focus on the sub-allocation within each asset class. For instance, within the equity portfolio, how much should you allocate to large cap, mid cap, small cap, and foreign stocks?

Continuing with equity portfolio construction, think of this portfolio as consisting of a core and a satellite portfolio. The core portfolio simply aims to generate market-matching returns. Use low-cost large cap index funds or exchange-traded funds (ETFs) in your core equity portfolio. To that add low-cost foreign equity exposure for diversification through a low-cost ETF or index fund. Allocate 60-70 per cent of your equity exposure to the core equity portfolio.

Within the satellite equity portfolio, you aim to generate market-beating returns. This is the segment of your portfolio where you express your preferences and market outlook. You can use actively managed funds, mid and small cap funds, sectoral funds, factor index funds, PMS or even direct stocks.

Construct your fixed-income portfolio in the same manner. A fixed-income investment can have two types of risk. The first is credit or default risk where you are concerned about the borrower not returning your money. The second is interest-rate risk where you are concerned that a rise in interest rates could erode the market value of your investments.

In the core portfolio, pick products where you control both credit and interest-rate risk. Bank fixed deposits, Public Provident Fund, Employees Provident Fund, Post Office schemes, Reserve Bank of India and government bonds, and good credit quality short-duration funds belong to this basket. Allocate 70-80 per cent of the fixed-income portfolio to the core portfolio.

In the satellite portfolio, control one or neither of these risks. Long-duration bonds and funds, credit risk debt funds, and new age lending products belong here.

Review and rebalance your portfolio to your target asset allocation at regular intervals. Move money from an asset that has appreciated to the one that is underperforming, or make incremental allocations to the underperforming asset. And how frequently should you rebalance? Annual rebalancing should suffice.

Take a rule-based rather than a gut-based approach to investments. A gut-based approach brings your biases into play and can cause immense damage. A rule-based approach mitigates behavioural biases. Write down the rules for your target asset allocation, sub-allocation, and rebalancing and adhere to them. With a rule-based approach, you don’t have to worry about when to buy and sell. Your asset allocation rules will provide the answers.

Investment returns are not guaranteed but costs are, so keep costs low.

Stick to this simple approach. Remember that in investing, simple beats complex most of the time.

The writer is a Sebi-registered investment advisor and founder, PersonalFinancePlan.in