Things to be taken care of before creating a portfolio

For most of our life,we will be earning and spending money.

P Saravanan

For most of our life,we will be earning and spending money. Sometimes,we may have more money than we want to spend; at other times,we may want to purchase more than what we can afford. These imbalances will lead us either to borrow or save to maximise the long-term benefits from our income.

In spite of these imbalances,many of us wish to have a portfolio or a basket of assets,ranging from non-tradable financial instruments such as bank deposits,post office time deposits,national savings certificates,company deposits and public provident fund scheme to tradable instruments such as equity shares,commercial papers,private sector debentures,PSU bonds,equity shares,preference shares,gold,precious objects,real estate,antique and the like.

This is not an exhaustive list. Though everyone wishes to have a wide portfolio as mentioned above,many times investors forget some of the essential things to do before constructing a portfolio.

So,before embarking on the long-term activity of portfolio construction,one needs to ensure that other needs are satisfied. No serious investment plan should be started until one has adequate income to cover living expenses and has a safety net to cover if the unexpected occur.

Insurance

Life insurance protects loved ones against financial hardship should death occur before our financial goals are met.

The death benefit paid by the insurance company can help pay medical bills and funeral expenses and provide cash that family members can use to maintain their lifestyle,retire debt,or invest for future needs for example,childrens education,spouse retirement.

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Therefore,one of the first steps before constructing a portfolio is to purchase adequate life insurance coverage.

Cash reserve

Emergencies,job layoffs,and unforeseen expenses happen,and good investment opportunities emerge. It is important to have a cash reserve to help meet these occasions such as emergencies,job layoff and for any unforeseen expenses.

In addition to providing a safety cushion,a cash reserve reduces the likelihood of being forced to sell investments at inopportune times to cover unexpected expenses.

One should have a a cash reserve equal to about six months living expenses. Cash reserve means it need not necessarily be in the form cash rather,it could be in the form of investments,which can be be easily converted into cash without any loss in value. Money market instruments and banks accounts are appropriate vehicles for the cash reserve.

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Once the basic insurance and cash reserve needs are met,one can start a serious investment programme with their savings. Before starting a portfolio construction,investors should document a policy statement. The policy statement is a road map,wherein investors specify the types of risks they are willing to take and their investment goals and constraints.

All the prospective investment decisions must be based on the policy statement to ensure they are appropriate for them. The investors needs,as reflected in the policy statement and financial market expectations,will jointly determine investment strategy. Economies are dynamic that are affected by numerous industry struggles,politics and changing demographics and social attitudes. Thus,the portfolio will require constant monitoring and updating to reflect changes in financial market expectations.

The writer is an associate professor in finance and accounting at IIM Shillong