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The ‘booking profits’ syndrome

While the “book profits when the going is good” debate might apply to most kinds of stocks, it certainly doesn’t apply to diversified equity funds

A reader recently wrote in that he had booked ‘spectacular profits’ on the equity funds he had bought in 2011. Could we please tell him where to invest the money? The answer really is – ‘in the same funds that you just sold.’

Stock market gurus seem to have dinned one principle quite thoroughly into the heads of Indian investors - The markets are cyclical. Therefore, book profits when the going is good. While one can debate if this advice applies to all kinds of stocks, it certainly doesn’t apply to diversified equity funds. There are many good reasons for this.

One, as a retail investor who can’t time his entry and exit from markets, you invest in equity funds to ensure that a professional manager makes these calls on your behalf. If the market is under-valued, your manager may buy more stocks. If over-heated, he may book profits. Then where is the need for you to do buying and selling of your own?

Ha, but most Indian fund houses don’t time the markets either, smart investors will point out. Take Franklin Templeton or HDFC, they simply stay fully invested at all times and suffer setbacks to their equity fund NAVs if the markets fall. That’s true. But even in their case, the portfolio is actively managed to regularly replace stocks with poor prospects with those with superior ones.

If you look back at the performance of some of their diversified funds over ten or twenty years, these funds have created enormous wealth despite not timing the markets. In twenty years, top performing diversified equity funds in India have delivered a 20 per cent plus CAGR. Every ₹1 lakh invested in these funds has grown to ₹ 38.3 lakh! But the investors who actually made this return are few and far between. Many of them may have ‘booked profits’ when markets peaked in February 2000 or February 2008 (if they were lucky to catch the peaks, that is) and then re-entered at the wrong time. Others may have lost faith when markets bottomed in September 2001 or 2011 and exiting with large losses, never to return.

Two, as the reader found, booking profits is often the easy part. Once you book profits, where do you redeploy the money for equally good returns? If you invested in equity funds because you believe that they are the best inflation-beaters over the long term, why would you take out the profits to invest in a sub-optimal debt option?

This is why, to investors who ask us today if they should book profits, we usually offer this answer. Book profits only if you have reached the financial goal towards which you are saving. If not, stay put. So does this mean that once you buy an equity fund, you shouldn’t exit at all? You can, in three circumstances.

  • Sell your equity funds, if the goal for which you have invested will come up within the next three years. Bull and bear phases in India typically last 18-24 months and if you need your money within three years, you may not be able to wait out the next correction.
  • Sell your equity funds if they are abysmal performers. By abysmal performance, we don’t mean the fund clocking a 60 per cent return in the last one year while the category-topper is at 120 per cent. We mean a fund that has been lodged in the last quartile for a year or two and is lagging its benchmark for two years running.
  • Sell your equity funds if they have undergone a drastic change in mandate or risk profile, so that they no longer fit in with your objectives. If a large-cap fund has gone overboard on allocations to mid and small-caps or a value fund is going ga-ga over expensive FMCG stocks, you know that it no longer delivers on the objective for which you bought it.

Finally the ‘don’t-rush-to-book profits’ rule applies only to diversified equity funds which invest across market caps, sectors and themes. On thematic funds and microcap funds, past experience suggests that you should book profits if the returns have already exceeded your wildest expectations.