Creating 2 portfolios is crucial

There are two aspects to investing — the objective to accumulate wealth to achieve life goals and to generate short-term gains riding the market fluctuations. The first objective is achieved by creating goal-based portfolios, also called core portfolios. The second objective can be achieved by creating a trading portfolio, also called the satellite portfolio. In this article, we discuss why you should simultaneously consider creating both portfolios. We also discuss the optimal investment allocation to both portfolios.

Moderating biases

Suppose you invest only to achieve your life goals. You observe that the stock market exhibits high volatility, frequently moving up sharply only to decline later. Your extended family and friends generate handsome gains trading in the market. You are, however, contented ‘investing for the long term’. After a while, you are likely to regret not having traded like your extended family and friends to earn short-term gains.

Now, consider an alternative route. In this state, you aggressively trade in the market, trying to capture short-term market fluctuations in the market. You are bound to have your share of losses. If your market timing is not consistently good, you could lose a significant part of your capital. In this world, you may regret not building wealth for the long term.

When you create only core portfolios, you are said to suffer from a behavioural bias called hyperopia.

That is, you are concerned about the long-term wealth at the expense of short-term returns. When you create only a satellite portfolio, you are said to suffer from myopia; your concern is short-term returns at the expense of building long-term wealth. It is optimal to create both portfolios. That way, you can moderate both hyperopia and myopia. This is especially true when markets are volatile as is the case now.

Conclusion

Some individuals prefer to concentrate on the long term while others like to trade aggressively to capture short-term gains. So, the allocation preference for the two portfolios may vary across individuals. That said, an optimal split would be 70% core, 30% satellite, with a leeway of five percentage points. So, not more than 35% of your total investments in a year should be in satellite portfolio, with 30% being optimal. If you generate significant gains in the satellite portfolio, you can move some of the gains to your core portfolios. It is, however, not optimal to move money from core portfolios to the satellite portfolio.

(The author offers training programmes for individuals to manage their personal investments)