When my friends & clients ask me to recommend risk-free mutual funds and I tell them 2 things: Investing is never risk free & always start investing with the golden rule of Asset Allocation.
Asset Allocation is a structured and disciplined approach to investing your hard earned money. The focus and organisation that you bring to your professional lives should be mirrored in your approach to wealth creation.
The importance of Asset Allocation in Mutual Funds
Asset Allocation is a personal blueprint of investing. In mutual funds, it is the process of dividing an investment portfolio among different categories of Mutual funds such as Multi-cap funds, Short term funds, Liquid Funds, etc.
Historically, the returns in different category of mutual funds (Debt and Equity linked) have not moved up or down at the same time. Market conditions that cause one category to do well often cause another category to have average or poor returns. By investing in more than one category or sub-category of mutual funds you will be in a position to balance your losses and reduce your risk with better returns in another category of mutual funds.
Steps of Asset Allocation in Mutual Funds
The process of determining which mix of asset to hold is a personal one. It depends on three things
1. Financial Goals- They could be your net worth at the end of a particular no of years or the amount of income you want to have per month when you retire. If you are not sure about this our financial planner can help you define this.
2. Investment horizon – Define how much money you need to withdraw and when from your investment at what time. It could be for important life events such as a child’s higher education or smaller needs such as a family vacation or paying an insurance premium.
3. Risk tolerance- is your ability and willingness to lose a part of your original investment in return for higher greater potential returns. There is no formula to determine this- it is a very personal thing.
How to choose the Mutual Fund and Scheme?
Step 1: Based on the above, Identify the Mutual Fund Category- Equity, Debt or a Hybrid/ Dynamic Mutual Fund
.Step 2: Identify the Sub category. There are many subcategories in each kind of fund.
I define the following sub-categories for my clients in the two main categories
1. Equity Linked– Large Cap, Large Mid cap, Medium Mid cap, Small cap. For a medium term (1-3 years) horizon I typically recommend large cap funds. I do not shun mid cap- small cap funds even right now but may reduce their allocation in a portfolio.
2. Debt Linked– I suggest this based on the interest rate cycle and relative performance against equity linked funds. The choices are overnight funds, Ultra short term, Short term, Liquid or Cash funds and Fixed Monthly Plans. For an investment horizon of less than a year, I typically suggest that clients look at short term or ultra-short term schemes
.I think of these categories as accelerating and braking. Equity linked funds usually move the capital forward and debt linked funds act as brakes – usually safer in times of uncertainty or volatility in the markets.
Step 3: Select the Mutual Fund and Scheme. Different financial planners use different factors to evaluate mutual funds. There are 15-20 schemes for every fund available in any category, to select a few requires an understanding of what to look for to start with. Many retail investors look for schemes that give best returns which is a high risk approach. I look at the following factors
1. The fund house- Its track record and management.
2. Performance or Returns in multiple scenarios and investment horizons- from 1 month- 3 years.
3. Asset size and its turnover. It cannot be too low or too high. As Goldilocks said, it has to be Just Right.
4. The Portfolios composition – quality of stocks or bonds/ papers.
Step 4: Review the above. This is by far the most important step in Mutual Fund Investing. I personally review the investment of my clients, their goals once every quarter. In my experience, most investors underestimate the frequency of review needed. Many review it once- when they are filing their taxes or when the markets break new highs/ lows. This is very high risk behaviour and causes maximum damage as illustrated by the mutual fund performances in the last 3 years.
Does Asset Allocation give me maximum returns?
I think of investing my money like getting to a destination in a car. If I want to reach there in the fastest car, i run the risk of a breakdown or crash. Similarly, I urge my clients to not think in terms of highest return because aiming for it is very risky.
Asset Allocation optimises returns in a way that you are able to meet your financial goals and in my experience, in most cases, surpass them. Using the above method, I have helped my clients achieve a CAGR of 10% to 15% from their mutual fund portfolio.