Build Wealth with Confidence 3

A Portfolio Just for You

PORTFOLIO IS MUCH MORE THAN A LIST OF ALL YOUR INVESTMENTS
In personal finance, a portfolio means a collection of investments held by an investor, generally all the investments that one has. However , the words meaning in personal finance has evolved a great deal. At Value Research, we dont think it makes sense to use the word to just refer to a collection of all of someones investments. A portfolio is a lot more than a collection. For individuals, the best way to plan their investments is to have a separate portfolio for each financial goal. Different mixes of funds, stocks and other assets lead to different risk levels and different gain expectations. Most people find it difficult to match these to what they want. If youre asked, What is your risk level? youll probably give an answer of some sort but it will just be a gut feel thing. However , if you think of specific financial targets and think of the money needed for them, then you will be able to answer questions

about risk and returns precisely . For example, youll need money for your daughters higher education after three years. Youd like to buy a house at least ten years before retirement. Youd like to go on a vacation to Europe after two years. Youd like `2 lakh to always be available for emergencies. Each of these goals is very precise. The risk you can take with it, as well as the amount of money needed can be quantified quite precisely. Therefore, it is relatively easy to decide what kind investments should be made for each of

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them. When you follow our way of thinking, there is no concept of an individuals portfolio. Instead each individual must have many portfolios, one for each financial goal. The other important thing is that a portfolio is not simply a collection. It has different parts that fit together in specific roles and complement each other. There could be three funds, of which one provides gains and two stability. In hindsight, itll later appear that you could have stuck with one or the other but both types played a role. With time, you will know the basics of constructing a portfolio. One can accordingly build portfolios to meet investor specific needs from combination of funds that collectively work towards reading the desired financial goal. build the rest of the portfolio thats suitable to meet your goals. Goals that need to be fulfilled in the short-term are fundamentally different from long-term goals. Short-term goals are best fulfilled using fixed-income investments. These could be a bank or a fixed deposit or a post office deposit. For fulfilling long-term financial goals, the best option is to use a portfolio comprising of equity mutual funds, as equity is one of the asset class that has the potential to grow your money faster than inflation and not lose value in real terms. However, equity mutual funds can be volatile and thus only suitable for long-term investments. Over the short-term, the ups and downs of the stock markets could very well lead to temporary losses. Because of this, we do not recommend investing in equity mutual funds if your financial goal is nearer or about three to five years.

HOW TO BUILD A PORTFOLIO

The first step towards building a portfolio is to have a goal. Once you have that, then its relatively easy to

Advantage of a portfolio
A portfolio is not simply a collec What looks risky in the short-term

tion. It has different parts that fit together in specific roles and complement each other

can work very well in the long-term. What looks like volatility can actually bring great returns

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Investing for Growth

INVESTING FOR GROWTH INEVITABLY MEANS INVESTING IN EQUITY
For anyone who is good at doing business, the best way to invest is in your own business. Fortunately, because of the existence of stock markets, any of us can become owners (or rather, part-owners) in a business. We can reap the financial advantages of being owners with very few challenges that the real owners face. When you boil it down to the basics, you can only do two things with your money: 1) you can store it for safe-keeping; and 2) you can make it grow. Under option 1, there are two sub-options, the foolish one and the wise one: 1a) The foolish option: store it in a way that it loses a lot of its value because of inflation. 1b) The wise option: store it in a way that it doesnt lose much of its value to inflation. When we say storage of money, we mean all kinds of deposits, be it banks or post office or government deposits like the 5-year and 10-year National Savings Certificates or the

15-year Public Provident Fund and others. It could even mean actual cash. While cash doesnt make sense except for the small amount held in your pocket, the other options do have utility, especially in growing your savings. Still, this storage of money makes sense only if you need it after just a short period of timeanything from a few days to a couple of years. When you need the money just after a short-time, then it is better to invest it in a simple and safe way. For anything else, the only sensi-

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ble thing is to try and make the money grow as much as it can. And investing for growth inevitably means investing in equity. Equity could mean buying shares but for beginners it generally means investing in equity-based mutual funds. The emphasis to equity is necessitated because, in the long run, equity as an asset class has the potential to beat inflation and post real returns to achieve growth. To understand this, one should understand the source of equity profits. The ultimate source of profits in equity is the general growth of the economy. On the whole, stocks grow at a rate that is at least equivalent to the growth of the economy. And the inflation rate is built into the growth of the economy. If inflation is 5 per cent and the real economy grows at 5 per cent, then stocks on the whole will at least match 10 per cent. And thats just the average. On top of that, as an investor, if you are able to select stocks that are better than the average (through a good equity mutual fund, for example), then you can beat the general rate of economic growth by a fairly larger margin. Beating the average isnt easy, but if you keep a few simple rules in mind and go about things systematically, which is what you will be able to do by using this booklet. Through this initiative, you can educate yourself and be equipped to manage your finances better and achieve your financial goals. On the other hand, fixed-income investing (the storage option) is inherently linked to the inflation rate in the economy. Bear in mind though, that these gains are a mean, and average that all equity delivers. There are variations across individual investments and variations in time. To get the gains, you have to hold on for a minimum of three years and preferably longer.

Equity over savings

A saver can either adopt the The only reliable way of growing

approach of just saving money, or he can make it work for growing by investing it

your savings at a rate faster than that of inflation is to invest it into equity or equity-based investments

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Equity for the Long Term

IN THE LONG RUN ONLY EQUITY MANAGES TO BEAT INFLATION
At present, we Indians are under a specially sharp attack from inflation, with the rising price of goods all around us and its cascading impact on our finances. We have the lethal combination of high inflation and relatively low interest rates. This means that the inflation-adjusted interest rates that we earn from fixed-income investments like deposits are very low. What is worse is that at this juncture, neither of these problems is going to get solved in a hurry. It could well be years before fixedincome returns go up significantly. Hence, your portfolio needs exposure to equity investments, which has the potential to beat inflation. It is for this reason that your portfolio should have a significant exposure to investments in equity. For the normal Indian investor, investments in equity is psychologically the equivalent of risk. The risk of losing their money when investing in equity, keeps most Indians away from investing in

these instruments. We have been brought up to mentally equate investing in equity with the volatility of the stock markets. In reality, the returns from equity could be high. How can this be? How can returns from a type of investment that is volatile be high? The answer is to understand that the same thing can look very different at different scales. Heres a question that will demonstrate the point: How long is the coastline of India? The official answer is 7,517 km. Do you think a person walking exactly along the

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coast line from Gujarat to West Bengal would come up with this answer? What about an ant? If an ant walked the entire distance, would it come up with the same answer? How about an aeroplane? If you flew an aeroplane along the coastline, would you arrive upon the same answer? No. In each of these cases the answer would be very different. The ant may come up with an answer thousands of km higher because it would follow each nook and corner of the coast at the scale of millimetres. A human being would follow it on a scale of feet and come up with a lower answer. An aeroplane would follow it only on the scale of many kilometres and would come up with a far lower answer. Stock market volatility is a bit like this. If you track the markets everyday, you will get many ups and downs. If you track it once a month, there will be fewer ups and downs. On the scale of an year, the ups and downs would be even fewer and if you were to pay attention to the markets only once every two or three years, there would hardly be any volatility. Now, imagine the scenario once in a decade or for even longer periods. If you had invested in equity in 1990 and then bothered to check your investments only once in five years, then sometimes your investments would rise more and sometimes they would rise less but there would be nothing that would justifiably count as volatility. Over longer time such as a decade or more, the movement of Sensex evens out and reduces volatility. The moral of the story is quite clear: the idea that investing in stocks can lead to frequent losses only if you are a short-term trader. Over sufficiently long periods of time, you are like the aeroplane flying over the coastline. The little twists and turns that vex the ant are not your concern.

The power of equity

Inflation-adjusted interest rates It could well be years before fixed-

that we earn from fixed-income investments like deposits etc are actually negative

income returns rise above the inflation rate in any meaningful way and earn positive returns

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Why Equity Funds?

LOW COST AND DIVERSIFICATION ARE SOME OF THEIR BENEFITS
There are two ways of investing in equity . One, buy and sell stocks yourself. And two, invest through equity funds. The final goal is the sameto benefit from the potential returns that equity investing offers. However, the two activities are completely different. Unless you are an expert, it doesnt make sense to invest yourselffunds are the right choice. But why should this be the case? Heres an interesting comment that illustrates the reason. Warren Buffett is an 83-year old American who is widely regarded as one of the greatest investors ever. Hes the chairman of the conglomerate Berkshire Hathway whose investors have earned returns of an average 19.8 per cent for the past 50 years. At the recent Annual General Meeting of the company, an exchange with an investor was thus described by The New York Times: A shareholders asks if buying shares in the 20 best companies in the United States

would be better than investing in an index fund. Mr. Buffett replies that the results would probably be similar. Then he launches into a bigger point: there are professional investors, and then there are amateurs who invest. Being the former requires a lot of work and research. Several amateurs dont have the time or the inclination to do or do not have the necessary skills. The main problem for most people, he says, is trying to behave like a professional when you arent spending the time in the game needed to be a professional.

10 Build Wealth with Confidence CONVENIENCE

Buying mutual funds is very straightforward compared to investing in stocks. The paperwork needed is simpler and you dont have to open a demat account. Unlike stocks, its much easier to operate yourself as far as the transactions go by investing online. Also, when you invest directly without going through a broker (something thats not possible with stocks), you actually reap the benefit of the slightly lower cost. Moreover the mutual fund company will also have access to far more data and outside analysts than you would ever do. For instance, they would be visiting companies in which they invest and interacting with the management. Besides professional research and fund management, there are a number of other factors that make investing through a mutual fund the better choice.

SMALL TICKET SIZE

If you try to build a diversified portfolio with all types of stocks by buying them directly, youll need a relatively large sum of moneyat least several thousands to begin with. In mutual funds, you can start off by owning the same with a few thousand rupees.

PROFESSIONAL FUND MANAGEMENT

Its not just a question of the research, but also the constant monitoring of your investments and evaluation of the possible opportunities. A large mutual fund company may have many people carrying out the function of research, analysis and trading, all of which an individual investor will have to do the equivalent of for his portfolio.

DIVERSIFICATION
When individuals invest, they tend to build a portfolio in a bottom up approach whereas professional

Case for equity mutual funds

Unlike stocks, its much easier to When you are trading stocks your-

operate an equity mutual fund yourself as far as the transactions go by investing online

self, you are exposed to tax liabilities. In comparison, mutual fund investing is more tax efficient

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fund managers do it in top-down approach. This sounds complex but is a very simple idea. Bottom up means that if you think a stock is a good investment, you buy it. Thats the same as what you would do in top- down, except that in topdown each stock has to fill in a larger framework. A fund manager could have a set of rules defining the investments, such as there must be at least 15 or 20 stocks with no less than X per cent of the total portfolio. The stocks must be spread over at least 5 sectors with no sector being less than Y per cent. At least Z per cent must be held only in large companies because they tend to be more stable in bad times. And so on and so forth. Taken together, such rules define a framework which ensures that the portfolio stays diversified and safe from shocks that may strike individual stocks, sectors or types of stocks. Individuals who manage their own stock investing would rarely have the knowledge or the discipline to do all this continuously. Even if the investor has the knowledge and the discipline, hes unlikely to have the time for all the attention needed regularly to be up to date with their investments and its performance.

TAX EFFICIENCY
All equity portfolios need some buying or selling as individual stocks become more or less desirable. If you are trading stocks yourself then these transactions may mean a tax liability. However, in an equity mutual fund, this trading is done by the fund manager inside the fund. You dont have a tax liability because you havent made transactions yourselves. Investments in equity funds are subjected to zero capital gains tax, when the units are held for more than a year. But, if the units are redeemed before completion of a year, short-term capital gains at 15 per cent on the gains is applicable with an additional 3 per cent cess.

Case for equity mutual funds

Professional fund management You can start investing in mutual

makes investing in equity mutual funds safe, easy and profitable in the long run

funds through small sums of money, which makes them affordable and within ones reach

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Using Equity Funds

INVEST IN PORTFOLIO THAT MEETS YOUR SPECIFIC NEEDS
A knowledgeable investor thinks not in terms of investments, but portfolios. A common goal for a group of investments define them as a portfolio. A goal is defined by a particular purpose that the money will be used for, as well as a timeframe. Example goals could be Childs Higher Education which might be needed in 8 years, or House Purchase in about 5 years. As you can see, both the role of the goal in your life as well as its time frame can vary. Some goals have a precise time-frame (like a childs college education) while others, like an expensive holiday, would be nice to have but not crucial. Again, some things cant be postponed but others can be. There are also general goals like having enough emergency money.

THE DIFFERENT GOALS APPROACH

Conventionally, financial advisors treat all of an investors investments as a single portfolio and try and tune this to the investors self-

perceived risk-tolerance. They try to fathom this risk-tolerance by asking some questions and/or by rules of thumb based on age, income stability and some other factors. Such an approach is not necessarily useful. As youll realise when you think about some of the examples above, each goal has a different risk level. This risk level itself varies not just with the nature of the goal but with how far into the future the targeted goal fulfilment is. The lesson is clear: when the time-frame is long, the risks of equity are minimal and the returns are high.

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Therefore, adopt an approach to portfolio construction that is based largely on the time-frame for which you are investing. Here are a sample set of portfolios of varying risk levels and returns expectations. It must be noted that the perceived risk level is one of short-term volatility. If these portfolios are used for the specified time-frame, then the actual risk of loss is minimal. One important implication of this approach is that eventually, the long-term becomes short-term and then becomes imminent. Your eight-year old daughter will start her higher education in 2024 and thats a long-term goal. But by the time 2020 arrives, itll be a medium term goal and in 2022 itll be a short-term goal. Therefore, the way these investments are treated must change with time. Here are four sample portfolios. These dont have precise recipes in terms of the actual funds that you will select.

AGGRESSIVE GROWTH PORTFOLIO

Time Frame: 7+ Years. Designed to get good returns. It does so by emphasising equity investment and within equity, smaller and medium sized companies. The portfolio is likely to face heavy volatility and its value will likely see sharp falls many a time. However, the longterm gains can more than compensate for the volatility.

GROWTH PORTFOLIO
Time Frame: 5+ Years. Designed to generate growth from equity investment while keeping the equity risk somewhat limited. A bulk of the portfolio is made up of equity , with much less emphasis on smaller companies and a bulk of the investments are large cap funds that have a proven track-record. Even so, you can expect this portfolio to be volatile and in times when the stock markets decline, it will suffer from short-term losses. However, in the longer term the gains can balance out these losses.

Different hues of equity

If the money invested in a portfolio Hybrid equity-oriented funds by

is not needed for the longest time, then there is no harm with higher equity allocation

themselves can fulfil the need of providing growth without too much risk with regular asset rebalancing

14 Build Wealth with Confidence STABLE GROWTH PORTFOLIO

Time Frame: 3+ Years. This is a unique type of portfolio as it is entirely made of just a single type of fund, which are balanced funds. These funds typically have over 70 per cent equity and 30 per cent fixed-income investments. They automatically rebalance their exposure between equity and debt. The relatively large fixedincome exposure helps stabilise returns during volatile times. Also, the automatic rebalancing means that gains that the equity part makes during the times when the stock markets are doing well get shifted to fixed-income and are thus protected from losses when the stock markets are doing badly. Even so, these funds are not immune to volatility. From the risk standpoint, 70 per cent equity is quite a lot and when the stock markets decline, these funds will lose money, even though the losses should be less than that of other equity funds.

CONSERVATIVE GROWTH PORTFOLIO

Time Frame: 1+ Year. The conservative growth portfolio aims to limit risk. At the same time, the limited equity exposure in such funds tries to benefit from the growth potential of equity. This portfolio does so by using hybrid (balanced) funds, but of a subtype that is much more conservative, and thus relatively light on equity. In this case, the relatively low equity exposure helps stabilise returns during volatile times. However, like the equity-oriented hybrids in that portfolio, these will also implement automatic rebalancing between equity and fixed-income and thereby aims to protect portfolio returns. This portfolio has a much smaller degree of volatility than the earlier ones but even then the volatility does exist. When the stock markets go down sharply, you can expect some losses. However, these are likely to be covered up before too long.

Disclaimer: Nothing contained in this document shall be construed to be an investment advise or an assurance of the benefits of investing in the any of the Schemes of ICICI Prudential Mutual Fund. The information contained herein is only for the reading and understanding purpose. ICICI Prudential Asset Management Company Limited takes no responsibility of updating any data/information in this material from time to time. The recipient alone shall be fully responsible/are liable for any decision taken on this material.