How To Check Your Portfolio’s Health In Seven Steps

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As we look forward to an exciting year, now is a good opportunity to evaluate and reflect on your investment portfolio.

Here’s a quick 7-point checklist.

1: Do you have an emergency fund to help you in need?

The current covid issue serves as a timely reminder of the value of an emergency reserve. Salary reductions, job losses, medical expenses, and so forth might appear out of nowhere.

Maintain a minimum of 6-12 months of your monthly expenses in a safe debt fund or fixed deposit.

2: Is your current asset allocation mix consistent with your initial strategy?

Given the recent equity market rise, your equity allocation is likely to be significantly greater than your original targeted asset allocation.

If your equity allocation surpasses your original asset allocation by more than 5%, it’s time to take a profit and realign your assets to the original allocation.

For example, suppose you had a long-term asset allocation of 70% equity and 30% debt. If your asset allocation has shifted to 77% equity:23% debt, now is a good moment to sell some shares (i.e. 7% of your total portfolio) and shift to debt. This will restore the allocation to its previous 70% equity:30% debt ratio.

3: Are you adequately diversified across different investment styles in your equity portfolio?

Quality and Global Equities have become popular in recent years (US in particular). If you only looked at past returns, you are probably biased toward equity goods from these investment types.

To establish a well-diversified equities portfolio with minimum overlap, diversify evenly across five investment styles: quality, value/contrarian, growth at reasonable price, mid & small cap, and global equity.

This will assure reasonable long-term returns with lower volatility.

4: Does the Debt portion of your Portfolio carry interest rate and Credit Risk?

  1. Duration and credit risk are legitimate strategies for debt funds to boost their returns. They do, however, carry hazards.
  2. Credit risk funds face two key risks:
  • Credit risk – If underlying bonds default or get downgraded, there is a risk of NAV decline
  • Liquidity risk – In Indian bond markets, lower credit grade papers cannot be easily sold. Unexpected redemption pressures from investors can lead to closure (recall Franklin Templeton’s closure of 6 credit risk-oriented debt funds) or severe NAV reductions owing to distress sales.

3. Larger term funds are subject to Interest Rate Danger. Which is the risk of a higher NAV loss if interest rates rise. This requires more attention now, as we anticipate gradual increases in interest rates in the future.

4. Given that most of us consider debt funds an alternative to fixed deposits, most of our debt exposure should be in funds with a short duration (less than one year to reduce interest rate risk). And excellent credit quality (>95% AAA & equivalent exposure to avoid credit risk).

5. Even if you wish to incur interest rate or credit risk to increase returns. Keep it to less than 30% of your overall loan exposure.

5: Do you have the right return & volatility expectations?

  • Debt Funds & FDs – Lower your Return Expectation
    1. Going forward, as interest rates are low compared to the past, you should expect much lower returns from Debt funds and Fixed Deposits than what you enjoyed in the 3-5 year period pre-covid.
    2. For debt funds, the return expectation should be centred around the current YTM adjusted for expense ratio. YTM stands for Yield To Maturity, and you can roughly think of it as the weighted aggregate interest rate paid by the underlying bonds in your debt fund.
  • Equity – Earnings growth to drive returns
    1. In equity markets, with the high valuations at the current juncture. The next 3-5 year returns will have to be predominantly driven by earnings growth. The potential for valuations to increase and contribute to returns is very low.
    2. While the last 5 years have had paltry earnings growth, it is reasonable to expect above-average earnings growth over the next 5 yrs. 
    3. This expectation is driven by different earnings growth drivers such as Strong Growth in Tech Sector, Salary hikes, Pick up in Manufacturing, Banks – Improving Asset Quality & gradual pick up in loan growth, and Revival in the Real Estate sector. Other factors are the Government’s strong focus on Infra spending, Early signs of Corporate Capex, Low-Interest rates, a Favorable Global Growth environment, Consolidation of Market Share for Market Leaders, Strong Corporate Balance Sheets led by Deleveraging and Govt Reforms (Lower corporate tax, Labour Reforms, PLI) etc. 
    4. Early signs of a sharp pick-up in earnings growth are already visible
    5. The spread of the new Covid variant, Global Inflation and Central Bank actions remain key risks in the near term.
    6. On the volatility side, while it is impossible to forecast, based on history, a 10-20% temporary correction every year is almost a given. It should be considered normal equity market behaviour if it all happens. If markets fall more than this, then this can be a good opportunity for increasing equity allocation.

6: If markets fall, do you have a ‘CRISIS’ plan for your Portfolio?

  • Instead of making investment decisions in the middle of a market fall, a pre-loaded decision plan (If-Then template). It is a good way to approach a large market fall.
  • Pre-decide on a portion of your debt allocation to be deployed into equities if the market corrects. If Equity markets fall by:
  1.  20%, move x% from the pre-decided debt portion to equities.
  2. 30%, move y% from the pre-decided debt portion to equities.
  3. 40%, move z% from the pre-decided debt portion to equities.
  4. 50%, move the remaining amount from the pre-decided debt to equities.
  • You can decide the percentages based on your individual preferences and risk appetite.

7: Have you increased your SIP amount?

  • Investing more every year as your salary rises is a good practice. Check if you have increased your SIP amount. If not, this can be a good time to increase it.

While not a comprehensive list, the above 7 checks can ensure your portfolio is well prepared for handling whatever 2022 has in store for all of us.

Also Read: Should you invest in BoAt shares at the current price?

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