What exactly is a portfolio?

In a general sense, all the investments of an investor are collectively referred to as a portfolio. And this portfolio is meant to serve a few particular goals.

Here's how to build a portfolio of mutual funds.

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Define your goal

This may come as a surprise. But, you need a distinct portfolio for each goal. Why? Because you will be requiring the money at different points of time.

For instance, if you are saving for your wedding two years down the road and your retirement 30 years down the road, you will invest differently for each.

If saving for your wedding, then you don't have much time. So your risk cannot be too high. Neither can you put it in an investment which will be locked for a longer duration.

So you would not be able to consider an Equity Linked Saving Scheme which has a three-year lock-in period. These are diversified equity funds with a tax benefit. You will probably have to consider a debt fund (fund that invests in fixed return investments) or a Fixed Maturity Plan or a balanced fund (fund that invests in both shares and fixed return investments).

But, with a 30-year time frame you have lots of time on your side.

You could definitely consider equity funds � funds that invest in shares of companies.

Over long periods of time, the risk of investing in equity (and hence equity funds) is minimal and the rewards you can expect are high. 

At the broad level, money that is needed within the next three to five years must be in debt funds while money that is going to be needed after that can mostly be in equity funds.

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Define your asset allocation

Which means how much should be split between the various types of funds.

At a higher level, you need to decide how much to invest in equity funds and debt funds.

On the next level, you need to make selections within these broad categories.

Equity

The first step that you should take is to invest in diversified equity funds.

In our rating � which takes into account risk and return � we list funds on the basis of a star rating. Five star funds are the best you can have in your portfolio.

The September 2005 list of diversified equity funds has six funds with a five-star rating. HDFC [Get Quote] Equity has a below average risk grade and above average returns grade. In contrast, Franklin India Prima has an average risk grade and high returns grade. Thus, compared to HDFC Equity, Prima delivers higher returns but takes more risk in doing so.

This is the kind of insight that should be the key driver in deciding which funds should form the core of your portfolio. The core should be composed of funds that offer stability coupled with returns.

Don't judge funds based on the short-term performance, always look at the long-term performance.

If you still want to invest in some equity funds, then you could try sector funds and mid-cap funds. You could also look at funds like Kotak Contra and Magnum Contra which buy stocks that are not currently popular with other investors. All these can be referred to as non-core funds.

But look carefully at your current investments before deciding.

Let's say that you have invested in HDFC Equity and Franklin Bluechip. If you take both the fund manager's investments into account, 22% of total investments would be in technology stocks and 15% in auto stocks. Now, if you decide to invest in a tech fund or auto fund (both sector funds), you are taking the call that these two fund managers have not invested sufficiently in this sector and you are really keen on investing in such stocks. Go ahead only if you are certain that you want to invest heavily in these sectors.

To compare funds, you need to look at returns and risk. How to compare mutual funds and How risky is your mutual fund? will enable you to do that.

Debt

There are ultra-short term funds, known as cash funds, which are suitable for those who want to park surplus money for a very short duration, ranging for a few weeks to a few months.

Read Tired of your savings account? Try this to get a better understanding on such funds.

Then there are short-term debt funds for those who want to invest for a year or so.

Floating rate funds invest in instruments where the interest rate fluctuates depending on the overall interest levels in the economy. When one is unsure of which direction interest rates are headed, this is a good option.

There are also medium-term debt funds which have the potential to deliver higher returns than the above.

Gilt funds are those that only invest in government securities (investments with the government backing).

How many funds?

Even within mutual funds, diversification is a must. You must invest in different types of mutual funds and they should be from different Asset Management Companies (fund houses).

Looking at the actual portfolios that people send us, most investors tend to err on the side of having too many funds, rather than too few.

To make matters worse, many of these portfolios have funds of the same type.

In our opinion, two to four equity funds and one or two debt funds are quite enough for each type of fund.

Let's say you want to invest in short-term debt funds, floating rate debt funds, large-cap diversified equity funds and mid-cap funds.

What we suggest is:

Short term-debt fund: 1
Floating rate debt fund: 1
Large-cap equity funds: 3
Mid-cap funds: 3

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Evolving a portfolio

You must monitor your portfolio.

Let's say a fund might have been an excellent performer years ago but has consistently being underperforming.

In such a case, you should think of selling your units or at least stopping further investments if you are doing it via a Systematic Investment Plan. This is a scheme where you put in fixed amounts every month.

Also, if you have been saving with a 10 year time frame in mind and eight years later a bull run is on, it would be wise to take a look at your investments.

After all, you invested because you needed the money in 10 years time. Now, you need it just two years down the road. If you are making a good profit, sell your units and put them in a fund that is meant for a shorter time frame.

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Get cracking

Constructing a mutual fund portfolio is not rocket science. It just requires a great deal of careful thought.

Remember, it's your money so don't blindly play around with it.