Invest Mutual: When do we book profits, sell equity?

Many who had bought equities and invested in equity funds in 2007 -08 and subsequently being disillusioned, have recently sold/redeemed or are confused as to whether to sell now. They have waited for a long time to recover their losses. Now that there is profit, they want to quit. In fact some of them had started redeeming equity funds from Sep. 2013!! Those who entered the market in recent times did not expect such a run-up and do not want to make the mistake of not cashing out in time. Therefore, the question - Do we sell now? Do we book profits?

Unpredictable:

Note, no "expert" can ever really know the top of a bull market - is the Sensex going to be 40000 by 2020 or will it be more? Markets will ALWAYS remain unpredictable. What worked in the past may not work now in a different situation. In fact, we tend to look at markets that have run up in terms of how much they can fall!!.

Simple rules may not work:

Many have rules of profit booking, to book out when a certain 'special' level has been reached. Such decisions may all prove incorrect and one may miss a large part of the bull run that happens after exit and leave us regretting.

Investors also rightly worry about getting greedy. For those burnt badly in a bear market, the predominant thought is caution. Investors recall how they failed to get out at earlier highs and paid heavily for it. They get their daily dose of gyan from TV. The inherent unpredictability of markets make 'expert' recommendations ridiculous at times!!

Since we can never predict when that unknown torpedo will come out of the dark and smash the price of the stocks we hold, the question is: what do we do to build wealth systematically, attain goals and at the same time reduce risks?

Asset allocation and re-balancing as a way to systematically book profits:

Note - An investor, who is booking profits, is actually taking money out of equity, thus reducing exposure to equity. This really is an asset allocation decision. Each time money is moved in and out of equity markets, the investor is not 'booking profits' but re-balancing his money. What is this re-balancing?

First, one has to decide how much money one needs to have in equity based on what returns they need, the risk they can bear and when the funds would be required. Therefore, first, goals and the period should be very clear. An investor who plans to fund his own retirement after 20 years may want a higher proportion of his money in equities to allow time for growth and to beat inflation; similarly to fund your child's education 12-15 years later, you may decide to have a higher allocation in equity to beat inflation in education costs.

Based on our risk profile and goals we decide as to how much to invest in equity and how much in debt. In equity we include shares, equity mutual funds and we include fixed deposits, NCDs, bond funds, PPF in debt. (Investors can even include other asset classes like gold etc)

Let us say we have deliberately decided to have a 60-40 equity-debt ratio allocation. This allocation ratio is our strategic allocation, and is the most crucial decision one can make. Rebalancing is the deliberate, periodic realigning of a portfolio of investments to bring it back to the original target asset allocation. This way we systematically capture returns "book profits" - and reduce unintended risks created by over-exposure to one category. We do not bother about timing markets or worry too much on which way the markets would go. So, when markets go up and our equity valuation rises, we are automatically "booking profits" to bring back the ratio to 60-40 and reducing the risk of higher exposure to equity. Irrespective of where the market is, 60% of our money needs to be in equities..

An example would help us understand re-balancing:

Let us say an investor has decided to have a 60-40 ratio and has invested Rs. 60000 in Equity Mutual Funds and Rs. 40000.00 in Debt – comprising of FDs, Debt Funds etc. on January 01, 2015.

Assuming the debt portion is worth 44000.00 on Dec 31, 2015. Let us assume that the market was good and the equity portion has gone up to 120000.00. This would mean that the equity to debt ratio in the portfolio is 73-27 , which would mean a higher exposure(73%) to risky equity. Now after taking stock, the investor should reduce exposure in equity (redeem funds - sell equity, in other words, book profits) and invest in debt to bring back the ratio to 60-40.

If however, equity component has gone down, then one should reduce debt and invest in equity to bring the balance back.

This way not only you know how much to 'book' but you don't really care where the market is when you book profits. Following this gives you a freedom and takes out the confusion from investing. Moreover, your focus is not on what others are doing, but on your own portfolio.

So how does one go about this?

For a start

Evaluate your current portfolio
Decide the allocation as per your risk-taking ability. You may take assistance in this from a financial planner.
It will be difficult to make an exact ratio and you may allow yourself a small gap -for e.g. equity may go between 57% to 63%
The equity allocation can be increased to reach the desired level slowly, by means of SIPs.
Follow a policy of checking and re-balancing every 6 months - even a yearly review will be fine i.e moving assets to maintain the proportion

Re-balancing forces you to base your investment decisions on a simple, objective standard - Do I now own more of an asset than my plan call for.

Follow this and be relatively free from the emotional upheavals that market movements cause.

For those who still want to take a call - Look for potential downside

Those who still need to take a call may check market valuations (read this post) and see where the market stands today. The point to note is to look for how much downside could be there.

When one sees too many IPOs at super high prices and when every one and his uncle is bullish is a sure signal that it may be time to book some profits to reduce the equity proportion in your portfolio. This approach means looking for signs of a crack up.