A common query these days is whether to exit equity mutual fund holdings which have given 30-40 per cent returns in the last one year. Most of these investments have been done less than a year ago and investors want to understand if they should book profits and invest elsewhere.
This is typical when markets are at a high. Why not book profits and invest elsewhere? The strategy may work in stocks but the same is not true for mutual funds. Firstly, in mutual funds, there is a fund manager who is deciding which stocks to hold and which to book profits in. Individuals do not need to take these calls themselves.
Also, there is the reinvestment risk. Investors believe they can book profits and wait for markets to fall to reinvest. The only thing about markets which is predictable is that they are unpredictable. Overconfidence leads to investors believing they can predict market moves or investment outcomes.
Where to redeploy funds turns out to be even more difficult as the investor now wants an investment that can generate 30-40% p.a. returns, like the previous investment. Most investors end up choosing trending investments which have already moved significantly. There are many queries from investors who have made handsome gains in equity mutual funds to exit and reinvest into futures and options (F&O), a highly risky strategy which doesn’t make money. As per data from SEBI, 90% of individual traders in equity F&O segment incur losses.
Further, the biggest wealth creation happens when remaining invested. This is because markets have their ups and downs and missing the best days can cost dearly. Data shows that missing the best 10 days would reduce the portfolio value by 50%.
Again, short term profit booking has the risk of goals not being met. Investing always needs to be goal based and the constant portfolio churn can result in the actual goal value not being achieved as one cannot consistently generate 30-40% return in short periods. Also the constant change means the instrument chosen closer to goal will have to be less risky and hence will impact portfolio returns.
Profit booking, if done right, can create wealth. Very frequent intervention impacts compounding. Hence, profit booking should be done with the right rationale behind it, which is goal based or to maintain asset allocation (which balances the risk and reward in a portfolio).
Profit booking closer to a financial goal helps to safeguard the goal corpus. Profit booking is best done in a systematic way to rebalance the portfolio on an annual basis, if the asset allocation deviates by say more than 10%. For example, if an investor has 30% in equity and this allocation has moved to 50% due to market moving up, the investor can consider liquidating 20% of the equity holding to bring back the asset allocation to desired levels.
“Invest like a bull, sit like a bear and watch like an eagle” as ace investor Vijay Kedia observed.