As we look forward to an amazing year ahead, this can be a great time to revisit and reflect on your investment portfolio.
Here is a simple 7 point checklist…
Check 1: Do you have an emergency fund to tide you through emergency situations?
- The recent covid crisis is a good reminder of the importance of an emergency fund. Salary cuts, Job losses, Medical Expenses etc can come out of nowhere.
- Make sure you maintain at least 6-12 months of your Monthly Expenses in a Safe Debt Fund or Fixed Deposit.
Check 2: Is your current asset allocation mix in line with your original plan?
- Given the recent equity market rally, there is a good chance that your equity allocation is much higher than your original planned asset allocation.
- If your equity allocation exceeds your original asset allocation by more than 5%, it’s a good time to book some profits and realign them back to the original allocation.
- For Eg: Assume you have a long term asset allocation of 70% Equity:30% Debt. Right now say if the asset allocation has drifted to 77% Equity:23% Debt, this is a good time to sell some equities (i.e 7% of Total Portfolio) and shift to debt. This will bring back the allocation to the original intended 70% Equity:30% Debt allocation.
Check 3: Are you adequately diversified across different investment styles in your equity portfolio?
- The last few years have favored the Quality style and Global Equities (US in particular). There is a good chance that you are overallocated to equity products from these investment styles if you only went by past returns.
- Diversify equally across 5 different investment styles – Quality, Value/Contrarian, Growth at Reasonable Price, Mid & Small Cap, Global Equity to create a well-diversified equity portfolio with low portfolio overlap.
- This will ensure reasonable returns over the long run with lower volatility.
Check 4: Does your Debt portion carry Interest Rate Risk and Credit Risk?
- Duration risk and credit risk are legitimate ways for debt funds to increase their returns. However, they also come with risks.
- Credit Risk funds have two major risks –
- Credit risk – The risk of NAV decline if underlying bonds default or get downgraded.
- Liquidity Risk – Given that the lower credit quality papers cannot be sold easily in Indian bond markets, unexpected redemption pressures from investors can lead to closure (remember closure of 6 credit risk oriented debt funds by Franklin Templeton) or sharp NAV declines due to distress sale.
- Higher duration funds run Interest Rate Risk – the risk of a higher NAV decline if interest rates move up. This requires more attention now as we expect interest rates to gradually increase going forward.
- Given that most of us view debt funds as an alternative to fixed deposits, the majority of your debt exposure should be in funds with low duration (less than 1 year to reduce interest rate risk) and high credit quality (>95% AAA & equivalent exposure to avoid credit risk).
- Even if you want to take interest rate risk or credit risk to improve returns, it is better to limit these risks to less than 30% of your overall debt exposure.
Check 5: Do you have the right return & volatility expectations?
- Debt Funds & FDs – Lower your Return Expectation
- Going forward, as interest rates are low compared to the past, your return expectation from both Debt Funds and Fixed Deposits should be much lower compared to what you enjoyed in the 3-5 year period pre covid.
- For debt funds, the return expectation should be centered 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
- In equity markets, given the high valuations at the current juncture, the next 3-5 year returns will have to be predominantly driven by earnings growth. Potential for valuations to go up further and contribute to returns is very low.
- While the last 5 years have had paltry earnings growth, it is reasonable to expect above-average earnings growth over the next 5 years.
- This expectation is driven by different earnings growth drivers such as Strong Growth for Tech Sector, Salary hikes, Pick up in Manufacturing , Banks – Improving Asset Quality & gradual pick up in loan growth, Revival in Real Estate sector, Government’s strong focus on Infra spending, Early signs of Corporate Capex, Low Interest rates, 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.
- Early signs of a sharp pick up in earnings growth is already visible
- Spread of the new Covid variant, Global Inflation and Central Bank actions remain key risks in the near term.
- On the volatility side, while it is impossible to forecast but based on past history a 10-20% temporary correction every year is almost a given and should be considered to be normal equity market behavior if at all it happens. If markets fall more than this, then this can be a good opportunity for increasing equity allocation.
Check 6: If markets fall, do you have a ‘CRISIS’ plan?
- Instead of making investment decisions in the middle of a market fall, a pre-loaded decision plan (If-Then template) 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 in case market corrects –
- If Equity markets fall by ~20% then Move x% from the pre-decided debt portion to equities
- If Equity markets fall by ~30% then Move y% from the pre-decided debt portion to equities
- If Equity markets fall by ~40% then Move z% from the pre-decided debt portion to equities
- If Equity markets fall by ~50% then Move the remaining amount from the pre-decided debt portion to equities
- The percentages can be decided based on your individual preferences and risk appetite.
Check 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.
Happy New Year and Happy Investing as always 🙂