Picture this. You create a portfolio with a 10-year investment objective. This portfolio has unrealised gains at the end of five years. You fear that the market may decline going forward. Will you take profits and reduce your equity investments or will you continue to hold your investments with the unrealised gains? The question is important because the decision on whether to take profits or not is not always easy. In this article, we discuss why taking profits is better than fearfully staying in the market even if it means that you have to give up potential gains.

Asymmetric returns

Taking profits is, perhaps, the most difficult part of investing. Why? Suppose you take profits at the end of year 5 (investment horizon is 10 years) because you fear that the markets will decline going forward. What if the market moves up thereafter? For one, you will regret your decision. And this will have an adverse effect on how you deal with your investments subsequently. For another, taking profits could mean that you may not achieve your objective at the end of year 10, as equity offers higher expected returns than bonds.

But what if you continue to hold your investments? Suppose you invest Rs 10 lakh. After 5 years, assume your investments are worth Rs 20 lakh. The market can decline by 50 per cent in year 6 and wipe out your unrealised gains. Instead, suppose your investment value is Rs 5 lakh (losses 50 per cent) at end of year 5. Your investments will have to increase 100 per cent to recover your initial capital. And then accumulate gains to achieve your investment objective.

From the above, a powerful truth emerges about equity investments. You can lose your accumulated wealth quickly if markets decline. On the other hand, it is difficult to rebuild your portfolio if losses occur initially. That is why you should take profits when you are fearful of losing value on your investments.

reasons

You should use predefined rules to take profits for two reasons. One, you do not have the time to monitor your portfolio on a continued basis to take profits. And two, more often than not, because taking profits is not easy, you may decide to continue with your investments and expose yourself to high downside risk.

So, what rules should you create to systematically take profits? Suppose you require 15 per cent return each year to achieve your investment objective 10 years hence. You should necessarily take profits and capture unrealised gains above 15 per cent in any year. Invest the proceeds in bonds that mature at the end of your investment horizon. You should review your investments every half year to engage in this process.

But what if you fear the market will decline and your portfolio has so far earned less-than-required-return? Assuming you follow the core-satellite approach, continue your core investments through a systematic investment plan. If, however, your fear about a market decline surfaces within three years from the end of your investment horizon, keep about 30 per cent in core equity and move the rest to core bonds.

What about your satellite portfolio? Whenever you fear a market decline, take profits and invest the entire proceeds in short-term bank deposits. You can reinvest in equity once your fear subsides. You can engage in this process till the end of your investment horizon.

Taking profits when your portfolio is comfortably moving towards your investment objective is not so difficult. The issue arises when you expect a market decline and your portfolio has earned lower-than-required-return. You should still take profits based on the rules discussed above, for the consequences of a market decline are more severe than the regret of giving up potential gains.

(The author is the founder of Navera Consulting, a firm that offers wealthmapping and investor-learning solutions. Feedback may be sent to >knowledge@thehindu.co.in )

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