Portfolio Construction Rules
Master the essential rules for building a well-balanced mutual fund portfolio. Learn time-tested strategies for diversification, risk management, and optimal asset allocation.
Table of Contents
1. Core-Satellite Strategy
The core-satellite approach is the foundation of smart portfolio construction. It balances stability with growth potential by dividing your portfolio into two parts.
Core Holdings (60-70%)
Stable, predictable funds that form the foundation of your portfolio.
Large Cap Funds
30-40% of portfolio
Blue-chip companies, lower volatility
Index Funds
20-30% of portfolio
Market tracking, low cost
Flexi/Multi Cap
10-20% of portfolio
Flexible allocation, balanced
Satellite Holdings (30-40%)
Growth-focused funds for higher returns with calculated risk.
Mid Cap Funds
15-20% of portfolio
Growth potential, moderate risk
Small Cap Funds
10-15% of portfolio
High growth, high volatility
Thematic/International
5-10% of portfolio
Niche opportunities, tactical bets
💡 Why it works: Core provides stability during market downturns while satellites capture higher growth during bull markets. This balance optimizes risk-adjusted returns.
2. Diversification Rules
Category Diversification
Spread investments across different fund categories to reduce correlation risk.
✅ Good Portfolio
- • Large Cap: 30%
- • Flexi Cap: 20%
- • Mid Cap: 15%
- • Small Cap: 10%
- • International: 10%
- • Debt/Hybrid: 15%
6 categories = well-diversified
❌ Poor Portfolio
- • Small Cap Fund A: 35%
- • Small Cap Fund B: 30%
- • Small Cap Fund C: 20%
- • Mid Cap: 15%
Heavy concentration in one category
Optimal Fund Count: 6-12 Funds
< 5 Funds
Too Few
Concentration risk, lack of diversification
6-12 Funds
Sweet Spot ✨
Balanced diversification, manageable tracking
> 15 Funds
Too Many
Overlap, complexity, over-diversification
AMC (Fund House) Diversification
Don't put all your eggs in one fund house basket. Spread across 3-4 AMCs.
Rule of Thumb:
- No single AMC should exceed 35-40% of portfolio
- Distribute across at least 3 fund houses
- Reduces fund house-specific risks (management changes, regulatory issues)
3. Risk Management
High-Risk Category Caps
Small Cap Funds
High volatility, 40-50% drawdowns possible
< 20%
of portfolio
Thematic/Sector Funds
Concentrated bets, high risk
< 15%
of portfolio
⚠️ Combined Rule: Total high-risk exposure (Small Cap + Thematic) should not exceed 35% of portfolio
Add Stability Buffers
If your portfolio risk score is high (> 7), add stability through:
Debt Funds
10-15% allocation
Provides stability, reduces volatility, acts as cushion during market crashes
Gold Funds
5-10% allocation
Hedge against market downturns, low correlation with equity
Age-Based Risk Adjustment
4. Optimal Allocation Guidelines
Single Fund Concentration Limits
Model Portfolio Template
✨ This template balances growth potential with risk management for moderate investors.
5. Fund Selection Criteria
Expense Ratio Limits
Active Funds (Direct Plans)
< 1.5%
Equity funds should have lower fees in direct plans
Index Funds / ETFs
< 0.5%
Passive funds should have minimal costs
Impact: A 2% expense ratio costs ₹2L annually on a ₹1Cr portfolio. Over 20 years, high fees can reduce returns by 30-40%!
AUM (Assets Under Management)
Minimum: ₹500 Crores
Ensures liquidity and fund stability
Sweet Spot: ₹2,000-20,000 Crores
Large enough to be stable, small enough to be nimble
Be Cautious: > ₹50,000 Crores (for Mid/Small Cap)
Too large for smaller market segments, may underperform
Performance Consistency
Don't just chase highest returns. Look for consistency across market cycles.
- →Check 3-year, 5-year, and 10-year returns (if available)
- →Verify fund has beaten its benchmark in 3 out of last 5 years
- →Check downside protection: How much did it fall in 2020 crash?
- →Stable fund manager (same manager for > 3 years preferred)
6. Common Mistakes to Avoid
Chasing Returns
Why it's bad: Last year's best performer is often next year's underperformer
✓ Fix: Focus on consistent 5-year performers, not 1-year stars
Over-Diversification
Why it's bad: 15+ funds lead to overlap, diluted returns, tracking complexity
✓ Fix: Stick to 6-12 quality funds across different categories
Ignoring Expense Ratios
Why it's bad: High fees compound over time, eating into returns significantly
✓ Fix: Choose direct plans, target < 1.5% for active, < 0.5% for index
No Regular Plan
Why it's bad: Regular plans have 1-2% higher expense ratios vs direct
✓ Fix: Always invest through direct plans (not through distributors)
Market Timing
Why it's bad: Even experts can't consistently time the market
✓ Fix: Use SIPs for rupee-cost averaging, don't try to time entries
Not Rebalancing
Why it's bad: Allocation drifts over time, increasing unintended risk
✓ Fix: Review quarterly, rebalance annually or when drift > 5%
Quick Reference: The Golden Rules
60-70% core, 30-40% satellite
6-12 funds optimal
6+ categories for diversification
Small Cap < 20%
Thematic < 15%
Single fund < 25%
Expense ratio < 1.5%
3-4 different AMCs
Check Your Portfolio Health
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