In this article, SEBI-registered fee-only advisor Akshay Nayak – the newest member of fee-only India* – explains why simple portfolios make sense and how to build them.
About the author: Akshay holds an MBA in Finance from Great Eastern Management School, Bangalore. His website is akshaynayakria.com. His articles on personal finance and investing can be accessed here: akshaynayakria.com/blog.
* Fee-only India is an informal association of pure fee-only financial advisors. Launched in Sep 2017, it helps connect investors with SEBI-registered investment advisors without conflict of interest. Dr M Pattabiraman is a founder-patron of fee-only India.
Investors often load their portfolios with every attractive product they come across. This increases the number of products in the portfolio, making it difficult to manage them. It makes investors prone to mistakes, leading to below-par investment performance.
The key to success in investing for retail investors is to avoid mistakes and wrong decisions. A simple portfolio constructed with fewer products reduces the number of decisions an investor has to make, reducing the number of mistakes they commit. This automatically improves portfolio performance.
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The cognitive abilities of most people deteriorate as they age, making it difficult to handle complex portfolios with time. In the event of the early demise of an investor, their families may also be unable to handle complex portfolios. Considering all this, investors are better off keeping portfolios simple. Let us see how investors can build simple portfolios.
Most investors lack the time and knowledge required to manage portfolios. The passive approach to portfolio construction avoids excessive portfolio management. To construct passive portfolios, we use index funds for equity and index-like products for debt and periodically manage the portfolio’s asset allocation. The portfolio’s asset allocation can be decided based on the investor’s goals and risk profile. Passive portfolios aim to earn market returns.
A single Nifty 50 index fund can suffice the equity allocation. It gives investors exposure to two-thirds of the free float market capitalization of the Indian stock markets at a minimal cost. Direct plans of Nifty 50 index funds are available at an expense ratio of around 0.2% with almost all major mutual fund houses. The competition between fund houses in this category keeps costs low. Investors with a low-cost broking account may consider a Nifty 50 ETF which has robust daily trading volumes, no history of paying dividends and costs 5 to 6 basis points.
Investors willing to take on greater risk can use a combination of Nifty 50 and Nifty Next 50 index funds. Long-term rolling returns and standard deviation of the Nifty Next 50 index are comparable to that of the Nifty Midcap 150 index. This makes Nifty Next 50 an effective substitute for a midcap index fund. Nifty Next 50 Index Funds cost around 0.3%. A portfolio with a 50-50 blend between Nifty 50 and Nifty Next 50 costs around 0.25%.
For the debt component of long term portfolios, Employee Provident Fund (EPF), Public Provident Fund (PPF) and Sukanya Samriddhi Yojana (SSY) are automatic choices. There is no credit risk or interest rate risk in these products. It is very hard for other debt products in India to beat the post-tax returns of these three products.
To maintain liquidity in the portfolio, debt mutual funds can be used. Average portfolio maturity is an important criterion when picking debt funds. The average portfolio maturity of a debt fund is the weighted average maturity of the securities held within the fund. The average portfolio maturity of a debt fund must be significantly lower than the tenure of the goal it is chosen for. A simple choice within debt funds is Liquid funds. They invest in debt securities of the highest credit quality with a maturity of up to 91 days. A direct plan, the growth option of a liquid fund with extremely low credit risk, can be considered at a cost of 0.15% to 0.2%.
Indexation benefits are now unavailable on debt funds, but they may still be preferred over bank fixed deposits because they offer more flexibility. The tax liability in debt funds is deferred until redemption. This facilitates uninterrupted compounding until redemption. Interest income from bank fixed deposits is subject to tax at slab rates every year. Debt funds allow systematic investments and withdrawals without penalties, unlike fixed deposits.
Simple portfolios built with a few low-cost products are easy for investors to understand and manage. They can be as effective as a complex portfolio in helping investors achieve their goals. Therefore, investors would benefit from embracing simplicity and avoiding complexity when constructing portfolios.
“When there are multiple solutions to a problem, choose the simplest one.” – John C. Bogle.
To work with Akshay, you can contact him via his website akshaynayakria.com.