Fundamentals of Investing – Part 2

Fundamental principles of investment

(Continued from previous article)

Last time we talked about the benefits of starting investments early and making these regularly. Also the importance of looking for higher returns and keeping expenses low in making these investments was highlighted.

Following are the remaining fundamental principles of investment:

3) Diversification   

  • Just as it is said, “Do not keep all eggs in one basket”, it is wise to put your money in different investment assets. This is called diversification and it is used to manage the risk in investments. Investment risk refers to the chance of getting less than the expected returns or the chance of losing part of invested amount itself.
  • Diversification is a well established principle. It reduces the risk because if one investment asset in your portfolio is performing poorly, another one would be making up for the loss by giving better returns.

Diversification can be achieved by investing across different countries, in different asset classes (equity, debt, real estate, gold, etc), in different securities (various stocks, bonds, fixed deposits, etc), and across different maturities (short, medium or long term as per time available for achieving financial goals).

Mutual Funds offer diversification even for small investors, as whatever amount is invested in a Mutual Fund scheme gets further invested in various asset classes or securities as per scheme objectives.

4) Asset Allocation 

  • Asset allocation is the most important decision you make in your investment process. It serves the purpose of diversification required in portfolio to manage investment risk, keeping in view the expected return to achieve financial goals as and when due.
  • If all the investable funds are weighted as 100, the investor decides what percent of the funds go to each asset class, viz. equity, debt, real estate, gold, etc as per available investment options, and how much to be kept in cash or cash equivalents.

How one decides asset allocation depends on investor’s age, risk tolerance, time horizon of financial goals, and the requirement for current income vis-à-vis future income.

As per a thumb rule, a person should have (100 – age) % as equity part in investment portfolio. A person who is 30 years of age should be invested in equity to the extent of 70% (100 – 30). As his/her age increases, equity portion must be reduced accordingly. The logic behind this rule is that a younger investor has more time to handle the ups & downs of the equity market.

But for customizing asset allocation for a family, the other parameters as specified above have to be duly considered.

5) Security Selection  

It is only after the allocation ratio of each asset class is decided that one goes on to select individual securities within each asset class. Now again due consideration is given to the factors of investor’s risk tolerance, time horizon and income requirement. Tax efficiency and other aspects of the investment securities are also considered during this step.

There are many investment options available, providing income and growth oriented. Mutual Funds are a good avenue for actual investments as per the decided asset allocation. Each Mutual Fund scheme has its declared investment objective and philosophy according to which the professional fund manager invests the collected fund in individual securities.

6) Portfolio Re-balancing          

It is very essential for an investor to remain consistent with the original asset allocation plan. The portfolio of investments thus created should be periodically monitored and rebalanced, either annually or as per requirement. This is required because during the elapsed period, the original proportion of different asset classes in portfolio gets disturbed and changed substantially.

Suppose the original asset allocation was Equity 50%, Debt 40%, Gold 5% and Cash 5%. On annual monitoring it is found that, mainly due to rise in prices of equity stocks in the portfolio, the proportion has changed to Equity 65%, Debt 28%, Gold 3% and Cash 4%. Now portfolio rebalancing is essential for bringing the ratios very close to the original proportion. This can be done by selling the excess equity in portfolio, and investing the proceeds into debt/gold and keeping a small part in cash.

Re-balancing not only makes us stick to our original asset allocation but also helps in maximizing returns by way of booking profit when market prices have risen and buying when these are at a low.

7) Monitoring and Review 

This is very important in investment process. It should be ensured that the performance of the funds or stocks held in portfolio is in line with your expectations. Consistently bad performing funds have to be replaced with better ones.

The asset allocation decided earlier may itself be needed to be revised. There are certain economic developments which have long-term impact on portfolios. For example, inflation rate and the interest rate movement affect stock and bond prices to a great extent. The asset allocation also needs to be revised when some major development internal to a family takes place, or when financial goals of the family are met one by one.

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Sukhvinder S SidhuThe writer, Sukhvinder Sidhu, is a ‘SEBI registered Investment Adviser’ and a ‘Certified Financial PlannerCM’. He writes to contribute his bit to create financial awareness, so that readers take right personal finance decisions for a better financial life for themselves and their families.
Know more about him.