Why New Investors Should Start With Some Allocation To ETFs As They Build Their Portfolio ETF aims to deliver the same performance as the underlying index, i.e., generate returns similar to the underlying index

By Chintan Haria

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As an individual, you might have several dreams and goals that you would like to achieve. These could range from buying a house and planning for your retirement to buying a car and taking family vacations. Each of these dreams would be as unique as you in terms of how and when you want to achieve them. Thus, you need to create your customized financial plan that can guide you on your investment journey and ensure that you have saved up enough money to fulfill your financial dreams.

Creating a customized financial plan

The first step towards creating a financial plan is to identify each of your goals, the time frame for achieving these goals, and the returns required. The next step is to determine your risk tolerance; this will influence the level of risk that your portfolio should take and impact the type of instruments in which you invest. Once you have determined the above, you need to start creating an investment portfolio. One of the most important things to remember while creating an investment portfolio is to make sure that it is well-diversified. This will ensure that sharp movements in any one asset class do not have a big impact on your overall portfolio returns. The best way to achieve optimal portfolio diversification is through asset allocation, i.e., investing in a range of asset classes such that the overall portfolio risk is within your tolerance levels. Generally, equity investments are considered riskier than debt investments and asset allocation can help you achieve an optimal balance between the two.

Asset allocation to ETFs

Many new or first-time investors tend to shy away from equity investments due to their inherent volatility. However, many of these investors may actually take some exposure to equities due to their long-term investment horizon. For such investors, a small allocation to exchange-traded funds (ETFs) could be ideal.

ETFs are a type of investment fund or basket of securities that are traded on the stock exchange. Most ETFs replicate an index and these investments are held in the same proportion as their weight in the index. As a result, an index ETF aims to deliver the same performance as the underlying index, i.e., generate returns similar to the underlying index.

This investment vehicle can be especially beneficial to a new investor for the following reasons:

Exposure to equities: Equity asset class in a shorter time horizon is inherently volatile and can go through periods of sharp movements. For most investors, whether new or seasoned, selecting the most appropriate stocks or funds to invest in can be challenging. ETFs resolve this problem by investing in all the constituents of the index. Thus, they are an easy way to familiarize yourself with the equity markets without having to worry about stock selection.

Diversification: The benchmark index usually covers a large number of companies across sectors and industries. By investing in a single ETF, you can gain exposure to a wide range of stocks and diversify your portfolio. For example, the Nifty 50 index comprises the stocks of 50 leading companies in the country, spread across various sectors. A Nifty 50 ETF would give you exposure to all these companies, thereby helping you achieve diversification.

Ease of investment: ETFs are listed on stock exchanges and can be traded (bought or sold) at any time during market hours. New investors will find comfort in terms of ease of investment.

When creating an investment portfolio, an investor has the option to invest in a wide range of assets and securities. You must ensure that you chalk out an optimal asset allocation strategy that adheres to your risk constraints and can potentially generate the required returns. From that perspective, a small allocation to ETFs would be ideal.

Chintan Haria

Head- Product Development & Strategy, ICICI Prudential AMC

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