The art of investing and making the right choice out of available investment tools has the power to transform an unstable financial future to a financially secured future. Building a model portfolio is a great way to begin this journey.
A model portfolio is a group of diverse assets that you blend into a portfolio. A lot of decisions go into making this portfolio. A model portfolio gives you the option to hedge your risks through diversification. It is also important to consider risk as a factor.
The idea behind this is not just to look at long-term financial goals. It should also be able to satisfy your current pressing needs and leave enough liquidity to help you manage your expenses. It is a balancing act between long-term and short-term goals over a period of time.
Creating a good model financial portfolio is a process, involving both quantitative and qualitative factors. There are a multitude of factors that need to be considered. It also involves a bit of soul searching to find out the investments that you feel comfortable with, as well as the risks you are willing to carry in your portfolio.
Here are simple steps you could begin with while creating a model portfolio.
What A Model Portfolio Should Look Like
A model portfolio is a diverse mix of assets including stocks both large and small, government bonds, debt, and other forms of assets. Usually, a model portfolio is created through a lot of research and analysis.
Ideally, model portfolios are created financial advisors who help you take care of the portfolio on a day-to-day basis, taking away a lot of work and effort from the customers.
Basic requirements for building a model portfolio
Quantified financial goals
The foundation of a financial portfolio is your financial goals. Identifying what you are saving for is the first task that you need to do when designing the portfolio. The most common financial goals include the following:
Creating a legacy
Buying a house
Buying a car
Planning for retirement
Listing down your aspirations is the first step. Next, list down the horizon alongside each goal, i.e. the time after or by which you need to do the same. Be realistic while you do this.
The next step is to quantify your goals, i.e. estimating the funds needed for each goal. Don’t worry about inflation, just yet, note what you feel would be needed to complete each one. The longer the horizon is, the easier it is usually to save up for. This first step clarifies the amount of money you would need to make sure that you meet your goals and also at the same time have enough to meet your daily needs.
Your disposable income
After you list down your goals, the next step is to figure out your disposable income. This refers to the amount that you have to invest, after taking care of your monthly expenses.
Disposable income = Total income – Total expenses
This is a very crucial step. As you grow, your disposable income is also likely to increase. So you may have more money to invest as you grow. It is important, to begin with, what you have right now, and what you can do now. When you have more to invest, you can reorient your portfolio accordingly.
Every investment comes with a certain risk. Some investment decisions will carry more risk than others. Finding out your risk profile is a critical step in figuring out the best portfolio for you. Depending on your risk appetite , you will be able to filter out the investments that you are comfortable with.
This may seem like a stiff task because this is not an easy thing to figure out. Here are some basic questions that can guide your thinking on this.
1. How do you or would you behave if the savings you have done increase and decrease?
2. Are you better off, mentally, with a small, steady return rather than a large return?
3. Are you comfortable putting your money in something where you are not sure if the returns will be guaranteed?
Determination of your risk appetite is important so that you can choose the right investment avenues. A financial advisor may be a good option to consider here to help you in the process of understanding the risk profiles, for you personally, and also for the investment avenues you are considering.
It is also important to spend time assessing the risks associated with each of the asset classes you are considering. Having a fair understanding of this allows you to understand which assets are right for your portfolio and which ones aren’t.
Finding the right balance
The next step and perhaps the most important is to find the right balance between the various asset classes and the risk profiles you have chosen. You should make sure that you are blending the assets in a way that gives you the risk profile that you are comfortable with. You can balance the portfolio with both high-risk and low-risk assets. You could also choose to go with safer options and hence create a steadier portfolio.
The more research and time you put into this step, the better the results will be. Understanding each asset class closely, analyzing the performance of these assets in the past, the projections for the future, general stability of these assets, all are important criteria to consider.
Building a model portfolio is all about following the above steps and finding that sweet spot, the portfolio that works for you. Further, to ensure that your financial portfolio is aligned with your financial needs and investment strategy, here are some things that you should keep in mind:
Things to Keep in Mind
Inflation eats into your returns
When planning your financial goals, consider the effect of inflation on your savings. Inflation reduces the purchasing power of money and when you are planning over a long-term horizon, the corpus should take into account the inflationary adjustment needed. Go with a fair assessment of the inflation based on historic data and you can add a sufficient buffer to make sure you have covered all your bases. It is also safe to assume that the amount of money you are investing would also go up as the years go by, and this plus the returns should cover for inflation but it is still advisable to account for inflation, even if you don’t do it when you get started.
Asset allocation and diversification are the holy grails of your portfolio
We have been warned against having all the eggs in one basket all our life. The same is the case with creating a portfolio too. The very nature of the market today is to be volatile. Diversification helps in spreading the risks over different investment instruments so that if one fails to deliver the results, the other hopefully compensates. Pick a range of investments that do not all move up and down together.
Do not overlook tax planning
When you are picking investment avenues for your portfolio, their tax efficiency should be a key consideration. Different investment instruments have different tax implications and if you are smart about it, you can choose tax-efficient assets that not only maximize your wealth but also help in saving taxes. For example, Section 80C of the Income Tax Act, 1961 lists down several investment instruments which give you tax benefits on your investments. So, plan your taxes when investing to reduce your tax liability and increase your disposable income.
Do not forget to plan for emergencies
Lastly, plan for rainy days. Emergencies might call upon you out of the blue and you should be financially prepared to face them. Creating an emergency fund is, therefore, essential. Put aside at least six months’ worth of your income into a liquid fund which can be withdrawn when needed. Invest in insurance plans to get compensated for the financial loss that you might suffer in emergencies, especially in case of premature death and medical contingencies.
The Bottom Line
A model portfolio is a great tool if you are looking at investing. But creating one is not without its pitfalls and risks. Having a clear plan is the first step. Clearly articulate your goals, your aspirations, and what you are trying to achieve. This will give you a great deal of clarity and will ensure that you are not going all over the place with your portfolio.
It is always a good idea to consult with advisors or use tools that will help you create and manage the portfolio. At the end of the day, you are investing your hard-earned wealth into this portfolio and you need to make sure that it is designed to do the job that you expect it to do.
It is also important to keep a close watch on what’s going on and to take action in case changes need to be made. It also helps to remember that the goals are long-term, and there may be short-term fluctuations. So you have to be measured and smart with your changes. A model portfolio does a lot of the work for you once you have created it. Making it is the difficult part. With care, in-depth analysis, and a proper plan, you will be able to achieve your financial goals.