Individual investors have more investment options than ever before. But too much choice is not good. It adds pressure and confusion to the decision-making process. Faced with thousands of passive funds and actively managed funds spanning numerous categories, it is even harder to design an effective portfolio.
As a result, investors often struggle with putting investment decisions into practice. Many people accumulate holdings over time, and the percentage allocated to a fund may or may not be a good fit for their time horizon and investment goals.
To use a fund effectively, get these two questions right. They will go a long way toward improving your investing outcome and avoiding major mistakes.
What is the appropriate time horizon for holding a fund?
Although academic finance traditionally defines risk as volatility (or standard deviation), the real risk investors face is that of not having enough assets available to meet their goals.
Matching the recommended minimum holding period with the expected time horizon can reduce this risk.
Equity mutual funds are a fit for long-term goals because they’re more likely to generate losses in the short term but have better growth potential over longer periods.
Short-term and Medium-term debt funds are better positioned for near-term funding needs, but not likely to generate high-enough returns to support funding for long-term goals.
To get more clarity on this, you can divide your expected time horizon into four broad groupings to help you select the most appropriate funds:
- Short Term (1-2 years): You will need the money relatively soon, such as for an upcoming vacation, new car purchase, or major home improvement.
- Intermediate (2-6 years): You will need the money over a slightly longer time horizon, such as saving up for the down payment of a home, planning a wedding, or upcoming tuition payments for a child currently several years away from college.
- Long Term (6-10 years): This group targets assets for somewhat longer-term goals, such as college savings for a child in elementary school or wedding of a child in college. Maybe even purchasing a vacation home.
- Very Long Term (>10 years): This is years into the future, such as building assets for retirement or investing to leave a legacy to children.
What percentage of my portfolio should I allocate to a fund?
This is another major question that investors face when determining how an investment fits into their portfolios: How large a position should it be as a percentage of the whole?
Investors often spend more time thinking about whether a fund is worth buying than they do about how to use it—that is to say, how much space it should occupy within a portfolio.
They then might end up with a large assortment of funds, with each one occupying a different percentage of assets depending on when it was purchased and how well it performed since that date.
This can lead to disastrous consequences at times: For example, during a bear market, portfolios overweight in growth-heavy funds will fare worse than more balanced portfolios. Or imagine a portfolio packed with tech stocks in 2022.
To address this issue, you can divide the category universe into four additional groupings based on a recommended maximum position size:
- Main/Stand-Alone (80% to 100% of assets)
- Core (40% to 80% of assets)
- Building Block (15% to 40%)
- Limited (up to 15%)
The size of each bucket spans a wide range, which gives investors significant leeway to fine-tune the percentage weighting for a given fund.
Funds with built-in diversification should corner the bulk of the portfolio. Specialised funds (such as sector funds or focused funds) should generally make up a smaller percentage of assets.
Remember...
Portfolio mistakes can have permanent negative consequences. To improve your investing outcome, get these key decisions right:
- Most investors have multiple goals, and each goal has a different time horizon and a different level of importance to the investor as an individual. Match the time horizon for a specific goal with appropriate portfolio holdings.
- You can’t avoid debt and only have outsize equity bets.
- You can’t avoid equity. You might find volatility unpleasant, but the real risk is not having enough assets available to meet your goals.
Access the Detailed Portfolio Framework here
Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter
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