An American investor, and the vice chairman of Berkshire Hathaway Charles Munger once said,  “Missing out on some opportunity never bothers us. What’s wrong with someone getting a little richer than you? It’s crazy to worry about this.”

If there are a few useful pieces of advice that an individual investor needs to follow while building one’s mutual fund portfolio, this is definitely one of them. Most of us often get carried away by seeing things like returns of best performing funds, new fund launches, what our friends and colleagues own in their portfolios, the trending thematic or sectoral funds and so on. As a result we end up owning a lot of mutual fund schemes in our portfolios, many of which are bought based on arbitrary advice or out of FOMO (Fear of Missing Out).

When we invest in such a haphazard manner, we invariably end up with a portfolio that is misaligned with our risk appetite and desired asset allocation. It also comes with several other issues such as overdiversification, lack of clarity when there’s increased market volatility, difficulty in making right exit decisions and so on. The end result is suboptimal investment outcomes.

So what is the advisable approach for building a mutual fund portfolio?

One of the commonly suggested exercises before one starts building a mutual fund portfolio is to identify the financial goals you are investing for – building a retirement corpus, buying a car, downpayment for a house, etc – and then plan your investments for each of these financial goals separately. While goal based investing may be a good way of planning your investments, many investors, either find this too tedious to implement or do not completely relate to it. As such, they simply opt to build a portfolio for long-term wealth creation.

Irrespective of the approach you follow, it is important to have a proper framework when you build your mutual fund portfolio to avoid some of the common mistakes we discussed above. Here are five important things you could consider while establishing such a framework.

  1. Define your asset allocation range – what is the minimum and maximum allocation you would maintain across different broader asset classes, i.e. domestic equity funds, debt funds, global equity funds, gold funds and so on. You need to take into account your risk taking ability and willingness, investment horizon and your allocation to other investments such as stocks, FDs, bonds, etc while deciding your asset allocation range.
  1. Within the above asset allocation framework, decide if you are comfortable to make allocation to tactical or non-core holdings such as sectoral funds, small cap funds, etc. If you are, then decide on an upper cap for such allocation. Allocation of more than 20-25% to such funds can be too risky. If you are not comfortable taking very high risk, it’s absolutely fine to stick to funds in core categories like Large cap /Index funds, flexi cap funds, midcap funds, corporate bond funds, etc.
  1. In order to avoid adding funds to your portfolio out of FOMO or without proper due diligence, invest in a mutual fund scheme only if you intend to allocate a certain minimum percentage of your portfolio to it. Typically allocation of anything less than ~5% to a mutual fund scheme is unlikely to add meaningful value.
  1. Decide an upper cap for the number of funds in your portfolio: Anything more than 8-10 funds may lead to overdiversification.
  1. Maintain sufficient diversification across funds of different fund houses, especially when you invest in actively managed funds. This helps in avoiding fund manager specific risk in your portfolio.

Investing decisions are often influenced by our behavioral biases. Having a structured portfolio construction approach can go a long way in reducing impact of such behavioral biases and help build a robust mutual fund portfolio. Of course, once you have your portfolio in place, it is equally important to monitor and review it periodically to ensure adherence to the framework. Finally, if you are not fully equipped to manage this yourself due to lack of knowledge or time, it may be apt to seek help from financial advisors. Remember that mutual fund investing is not just about investing in some best performing funds. There’s no substitute for having a structured approach based on proven investing principles.

For general educational purposes only and should not be construed as advice.

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