Is this the right time for Profit Booking in Mutual Funds?
September 20203 min read
Indian markets have seen extreme fall and equally extreme recovery in the last 6 months. If we look at the movement of Nifty 50 in March 2020; It fell from 11,200 to 7,610 in a matter of 20 days. It also came back to the levels of 11,200 in the next 4 months. After clocking a gain of almost 50% in 4 months, a lot of investors who have been investing for the last 2-3 years have now seen a significant profit in the portfolio. So, is this the right time for Profit Booking in the mutual funds? Or should investors wait for some more upside? What is the right approach to take for while booking profit in the portfolio?
We will look at all these aspects and much more in today’s blog.
What is Profit Booking?
Profit booking in simple terms is redeeming your investments to encash the profit in a fund. Profit booking can be done completely or partially. If an investor feels that there is good potential for a fund to give good returns in the future, he/she may do partial profit booking. However, if the future view on the market performance is uncertain then complete profit booking makes sense.
But, while taking any action on the portfolio, it is important to look at the cost impact and minimize them. Every mutual fund redemption transaction can attract two major costs: Exit Load and Taxation. Exit load is generally applicable for Equity funds and it varies from fund to fund. Taxation for Equity and Debt funds is different. You can get read the details of Mutual Fund Taxation here. Before doing the profit booking, ensure that the cost implications of the actions are minimum.
When is the right time to do Profit Booking?
Profit Booking needs to be done in three major scenarios: Skewed Asset Allocation, Nearing Goal completion tenure, Extremely overvalued markets. Let’s look at each of these in more detail:
Skewed Asset Allocation
During the bull run or when markets go up, Equity exposure in the portfolio tends to rise. If this exposure goes beyond the stipulated asset allocation number then it’s time to book profit. Asset Allocations are created based on investors’ risk appetite. Hence during market volatility, the performance of the portfolio can be disappointing due to increased equity exposure.
A way to deal with this is to define tolerance limits for equity in the portfolio. If the equity portion goes beyond that, then book profit and rebalance the portfolio. Remember higher equity exposure comes with high risk. Hence, keeping the asset allocation right helps in managing the risk.
Nearing Goal Completion Tenure
If your goal is 1-3 years away and if you have significant profits in funds, then it is a good time to book profit and move to safer debt funds. With long term goals, the major investment objective is always wealth creation. However, when you are on the verge of goal completion, the investment objective changes to Wealth protection.
And during this time, having exposure in Equity funds may lead to extreme volatilities. Hence, It is ideal to book profit when your goal is nearby. Some of the suitable debt fund categories for wealth protection are Ultra Short Term Funds, Low Duration Funds, and Money market funds.
Extremely Overvalued Markets
The above-mentioned factors are rule-based and easier to follow. However, this one is tricky and extremely difficult to get it right. A lot of investors try to identify market valuation by Nifty or Sensex PE. While it does give an idea of whether the market is overvalued or undervalued; it is not a definite indicator of valuation. There have been instances where markets when overvalued go further up and vice versa. Hence, it is difficult to get the exact time of entry and exit right.
To book profit using this factor, the investor needs to be updated on the market movement or needs to take the help of a financial advisor. However, more often than not, this parameter is difficult to execute. Hence, it is ideal to stick to rule-based profit booking strategies.
If the goal is the long term that is at least 7-8 years away, short term movement in the market shouldn’t bother you. With a long term horizon, any volatility must be treated as an investment opportunity as it helps with reducing the average purchase price. Profit booking if done right, helps in creating wealth. But if it is done too frequently then the compounding benefit does not work. Hence, make sure that you book profit with the right rationale behind it.
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