At the beginning of a new year, we want to reiterate an important point: Your primary objective to invest is to achieve a life goal, not to earn returns!

In this article, we discuss the reason why you should separate your urge to earn returns with the need to achieve goals. We then show how the core-satellite framework helps you do both.

Goal Vs Returns

Suppose you want to buy a house seven years hence. In a goal-based portfolio framework, you will invest in equity and bonds such that you earn enough return on your investment to make down-payment for the house.

A typical portfolio will contain a seven-year recurring bank deposit and a systematic investment in an equity fund of your choice. You will create this focused portfolio through automatic debits from your savings account every month. Further, given the approximate cost of your dream house and your savings each month, you can easily calculate the annual required return to accumulate the wealth needed to make the down-payment.

Suppose you need compounded annual return of 9 per cent. You now know that earning less than 9 per cent in any year could hurt your goal of making down-payment for the house in seven years. Earning more than 9 per cent return could be risky too! Why?

Suppose you invest ₹100 at the beginning of this year. You should have ₹109 at the end of the year, all of which you have to reinvest the next year to earn 9 per cent return.

So, you have to keep unrealised gains to the extent of your required return in your portfolio. You could take out money in excess of 9 per cent returns and invest it in fixed deposits once every year. This way, a market decline could wipe out less of your portfolio value! But you can do all of the above only if you invest with the objective of achieving a goal.

What if you invest to just earn returns? You will experience joy when the equity fund gives you a higher return. And suffer regret when it underperforms peer funds or its benchmark index. You will also suffer regret when the fund value goes up after you redeem your units! So, cause for emotional pain is high when your objective is to generate returns.

And that is not all. What will you do when you need money to buy a house? You may choose all your existing profitable investments to sell and generate cash. You will keep the loss-making ones, hoping that they will generate profits some day, as you are averse to taking losses. So, it can be a stressful experience each time you need to generate cash to pay for a lumpy expenditure.

Core-satellite framework

You have to meet certain needs in your life. Your core portfolio is a goal-based portfolio set up to fulfil your needs — such as buying a house, meeting your child’s college education and saving for your retirement. So, you do not have to rummage through your portfolio to sell profitable investments each time you have to meet a lumpy expenditure. Is that not a good reason for you to invest with a purpose?

Your satellite portfolio allows you to generate cash flows from short-term bets on the market, fulfilling your desire to earn returns. You can use these cash flows to spend on short-term desires such as splurging on an awesome experience or buying a luxury product.

You can choose to buy an active fund or an index fund for your goal-based portfolio depending on your risk appetite. Your bond exposure should preferably be in recurring bank deposits with the maturity equal to the time horizon for your life goal. You should actively trade on stocks and commodities to generate cash flows for your satellite portfolio.

The writer is the founder of Navera Consulting.

Send your queries to portfolioideas@thehindu.co.in

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