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One common mistake investors commit during profit booking is not having a plan for the redeployment of the money that comes into their account.
In the wake of the stock markets touching new highs recently, many investors are keen to book profits.
Concerns around high valuations and the re-emergence of the COVID-19 virus are fuelling this trend. Investors need to have an effective strategy for this task.
"Deciding when to book profits depends on a multitude of factors, such as investment objectives, risk appetite, current market dynamics, and the nature of the assets held," says Vijay Kuppa, CEO, InCred Money.
High valuations
At 24.6, the trailing 12-month price-to-earnings (P/E)) ratio of the Nifty 50 is almost on a par with its five-year average of 24.7.
On the other hand, both the Nifty Mid-cap 150 (current: 34.5, five-year average: 33.7) and the Nifty Small-cap 250 (current: 29.6, five-year average: 28.3) are trading above their five-year averages.
Investors must, therefore, consider profit booking, especially on the mid- and small-cap side.
"The quote from Warren Buffett, 'Be greedy when others are fearful and fearful when others are greedy' is a good guidepost. When equities are overly hyped and valuations seem stretched, consider profit booking," says Kuppa.
Rebalance portfolio
This point is closely related to the one above. The recent run-up in the equity market would have made many investors overweight on equities.
Profit booking is advisable at this juncture, especially if the current equity allocation exceeds the targeted allocation by 5 to 10 percentage points.
"Rebalance annually, either at the end of the calendar year or the financial year. Book profits first in the assets or sub-assets that show the largest variation from the original," says Mrin Agarwal, founder and director, Finsafe India.
Nearing a financial milestone
Profits should also be booked as you approach a financial goal. Move money out of equities and into a more stable asset class.
"Mitigate the impact of short-term volatility on your investments by transitioning gradually into high-quality debt or deposits, especially when approximately two years remain before reaching the designated investment goal," says Jay Thacker, member, the Association of Registered Investment Advisors.
If you continue to stick to equities, and the stock market witnesses a downturn, your goal (say, your child's college education) could get jeopardised.
Withdraw systematically
Markets are volatile, so do not book all profits in one go. Instead, phase your profit booking based on a schedule or by way of a systematic withdrawal plan (SWP).
This strategy will help you average out your exit price and prevent the need to time the markets. One-time profit booking can leave you with a feeling of regret if the markets climb further.
"This can be useful in two ways: It can help you in tax harvesting and you can plan the use of this withdrawal in some other asset or to reduce your liabilities," says Jinal Mehta, a certified financial planner and founder of Beyond Learning Finance.
Avoid predetermined targets
When booking profits in individual stocks, resist the allure of predetermined price targets or percentage gains.
Says Thacker: "Instead, focus on valuations, especially forward-looking metrics."
In the case of high-quality stocks in particular, which can compound steadily for a long period, profit booking should be done with a lot of caution.
Only a limited number of steady compounders exist in the market. If you hold one or a few of them, continue to do so even if they have become expensive. Reduce your position only if valuation has turned exorbitant.
Avoid a hardline, all-or-nothing approach when booking profits, especially if there is no imminent short-term financial goal.
"Predicting market highs and lows with precision is challenging, so stick to your financial plan and stay invested in alignment with your asset allocation," says Thacker.
Rid your portfolio of duds
A rising tide sometimes lifts all boats, including low-quality stocks. A bull market presents an opportunity to exit such poor-quality holdings.
Says Kuppa: "If the stock you are holding is a dud and does not have good fundamental prospects, it is better to sell it completely if a favourable opportunity arises."
Similarly, if a fund has been underperforming for a considerable period, it is better to exit and switch.
Have a redeployment plan
One common mistake investors commit during profit booking is not having a plan for the redeployment of the money that comes into their account.
Says Thacker: "Funds redeemed and left idle in a bank account depreciate in real terms. Have a well-planned redeployment strategy in place. Consider investing in high-quality debt or bank deposits."
Do not reinvest the booked profit in risky products.
"Investors sometimes fall prey to overconfidence bias during a bull run. This may not pan out well if the market surprises you with a bear move," says Mehta.
Reduce tax liability
While booking profits, try to optimise your tax liability.
Says Kuppa: "If you are making substantial profits in a few scrips, consider booking some losses in others to offset the gains and reduce your tax liability."
Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Feature Presentation: Ashish Narsale/Rediff.com
