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Business News/ Money / Personal Finance/  Building your portfolio? This is how you can use the two-bucket approach
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Building your portfolio? This is how you can use the two-bucket approach

Once you calculate how much you need to save and invest to reach your goals, here is a simple two-bucket approach to building your financial portfolio.

60/40 Portfolio is down more than 10% this year, Leaving it on pace for the worst drubbing since the financial crisis of 2008. (Bloomberg)Premium
60/40 Portfolio is down more than 10% this year, Leaving it on pace for the worst drubbing since the financial crisis of 2008. (Bloomberg)

When it comes to financial planning, the basic challenge boils down to how do you manage your income in such a way that you are able to support your current needs, aspirations, and future goals for your entire life. 

To add to the challenge, you will also need to take into account the obvious fact that after you retire, your income will stop but you will still have to take care of all your expenses. 

Then there are the sudden unplanned financial shocks, which usually come in the form of job losses, pay cuts, sudden medical emergencies, etc. 

The tough task at hand makes a good financial plan necessary for all of us.

A good financial plan will ensure that you have planned well for your various financial goals such as kids' education, retirement, buying a home, etc, and are also adequately prepared to handle the various curveballs that life throws at us. 

Once you calculate how much you need to save and invest to reach your goals, here is a simple two-bucket approach to building your financial portfolio. 

Your financial portfolio can be demarcated into two buckets: Safety and Growth.

Two-bucket approach to building your financial portfolio

Bucket 1: Safety bucket

This bucket is to plan for your emergencies. Under the safety bucket, you need to have an emergency fund – one that is adequate to cover at least 6-12 months of your basic expenses. The emergency fund gives you a safety net in case of any unexpected loss in income.

The amount set aside for this purpose should be put into safe, low-volatile, highly liquid investment options that give you decent returns and the flexibility to withdraw quickly with little to no charges. These can be your savings accounts, short-term deposits, or liquid funds.

You also need to buy an adequate health insurance policy that helps to take care of health-related emergencies and a term insurance policy that can help your dependents in case of premature death.

Bucket 2: Growth bucket

The growth bucket helps you plan for your short-term and long-term goals. Here, you can invest in different asset classes depending on your personal preferences and requirements. When making investment decisions, at the very least, you should take the following things into consideration,

Timeframe of your goal: If your goal is coming up within the next 5 years, your equity allocation should be lower (roughly 0 to 30%). If you have a longer timeframe, the equity allocation can be higher.

Return expectations: Equities have historically delivered returns higher than inflation over longer time frames (7+ years). If your goals demand higher returns than inflation, your odds of achieving them are better with a portion of equity in your portfolio.

Risk tolerance: Higher equity allocation, however, comes with higher temporary declines. If you cannot handle higher volatility, then you are better off having a lower allocation to equities.

Putting all these together, you can arrive at your preferred asset mix and make your investments accordingly to build your financial portfolio.

Common mistakes to avoid

In our investment journey, it is very likely that we will make some mistakes along the way. Watch out for some of these mistakes that usually don’t feel like one. 

Failure to start early: Most of us tend to put our investments on hold until our savings increase. But even small amounts can make a big difference in the long term. For example, assume an individual who needs Rs 1 crore at the retirement age of 60. If he starts at 45, he needs to invest Rs. 20,000 every month (assuming 12% annualized returns). But he starts investing at 25, and the investment required is just Rs. 1,600!

Not increasing your investment amount in line with your income increase: Similarly, even a small increase in your investment can make a significant difference in the long run. The portfolio value of a Rs.10,000 monthly SIP that grows at 12% per annum is Rs 3.5 crores after 30 years. When the SIP amount is increased by 5% every year, the portfolio value becomes Rs. 5.2 crores.

Investing only based on past returns: Past returns are never a guarantee of future returns. In the past two decades, only 27% of top-performing equity funds (funds in the top 25% on the basis of returns) in a particular three-year period continued to be top performers in the next three years. To put this in simpler terms, your odds of investing in a top-performing fund based on past performance were just 27%. So, past returns can never be the sole metric to evaluate a fund.

Along with it, you should also look at a number of other metrics such as consistency in performance across market cycles, ability to minimize falls during phases of market volatility, low churn, no over-concentration, investment strategy, and fund manager’s track record.

Lack of diversification: Different asset classes do well at different points in time. The best performers of one year can turn out to be the worst performers of another year. Similarly, different investment styles, sectors, market caps, and regions do well at different points in time. Therefore, it is always better to diversify your investments across asset classes, styles, market caps, and geographies. 

Overall, the simple ideas discussed above can serve as a good starting point for creating your personalized financial plan.

Mr. Arun Kumar, Head of Research, FundsIndia

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Published: 15 Oct 2022, 02:00 PM IST
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