If you thought selecting mutual funds was the only difficult part of investing, think again! In this article, we discuss why taking profits on your mutual fund investments is just as difficult.

We also show how you can moderate this difficultly by creating a process for profit-taking on your fund investments.

Regret aversion Your long-term memory could sometimes hurt your investment decision. Do you remember how you regretted the last time you observed the market climb up after you redeemed your mutual fund units? This memory could prevent you from taking profits on your investments the next time you want to redeem your units, even if you have significant unrealised gains. But guess what? It sometimes happens that the market turns down and wipes out your unrealised gains. So, what do you do the next time? You take profits quickly and end up regretting the decision.

So, whether you take profits quickly or hold on to your unrealised gains, you could regret either decision depending on the subsequent market movements. Fortunately, buying mutual funds has an advantage compared to direct stock investments; you can leave the profit-taking decision to the fund manager! You can choose the dividend option if you buy active equity funds — funds mandated to beat the benchmark index. When a mutual fund pays you dividend, you are essentially receiving cash flow that represents gains that the portfolio manager realised on the fund’s portfolio.

It could also include dividends that the fund received from the companies it invested in. Typically, fund managers pay dividend when they believe returning gains to the unit-holders is better than re-investing them.

Of course, a fund will not always pay dividends. In such cases, adopt a simple profit-taking rule. If you have invested in a fund to meet a life goal, you know how much return you require to achieve the goal.

Suppose this return is 11.5 per cent. If your investment in the fund generates a return of, say, 14 per cent, take profits to the extent of 2.5 percentage points and invest the proceeds in bonds. You may need to invest this money into the fund in any year when the fund generates less than 11.5 per cent return.

We call this process required-capital-at-risk rule; you should only risk as much capital as required to meet your life goal. Follow the above rule under two other circumstances as well — when you choose the growth option in active equity funds and when you buy index equity funds. Suppose you adopt the core-satellite approach to investing — each of your core portfolios is mapped to achieve one life goal and the satellite portfolio is positioned to take advantage of short-term movements in the market. You should adopt the required-capital-at-risk rule on your core portfolio.

Bond fund rules As for your satellite portfolio, you should adopt a pre-determined profit-taking rule. A simple rule could be to take profits if each investment carries unrealised gain of, say, 10 per cent.

If you invest in bond funds, your default choice should be dividend option. Why? The bond market moves based on the RBI’s interest rate policy and other factors such as unemployment statistics and inflation expectations.

You may find timing the bond market more difficult compared with the equity market. So you should leave the profit-taking decision on your bond investments to the fund manager. Of course, this decision has a cost.

Dividends distributed by bond funds are taxed, unlike in the case of equity funds. Finally, remember this: choosing the dividend option has a two-fold advantage. One, you are leaving the profit-taking decision to a professional who is much more informed about the market than you are.

And two, it reduces the number of decisions you have to make about taking profits on your fund investments, thereby making you regret less.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

Related Topics
comment COMMENT NOW