Distributors often say that they get several buy calls from fund houses, but rarely an exit call. Some may argue that exit calls are the domain of advisors and distributors, and most often, these calls need to be client specific. So, how then, should you be deciding when to exit a fund or when to book profits. Should it be only as per the goals of a client and never in-between? Should you never take profits when you think markets have run up very significantly? When should you be more actively booking profits and when should you refrain from doing so? When a fund underperforms for a year, should you switch or give the fund manager more time? If you decide to give more time, how much time should you give? Very tricky questions though very important, and questions for which there perhaps is no single right answer. We turned to the Straight Talking Brijesh Dalmia for his inputs on this tough question – here are his views, gleaned from over 2 decades of practical experience.

Disclaimer : No one can time the markets and no one knows for sure when to book profits or exit equity markets. Each situation is different and it cannot be generalized. The following article is my understanding over last 2 decades of my experiences in the financial market and dealing with investors. I don’t take responsibility for actions taken on the basis of this article.

Mr. Jain wanted to invest for creating a corpus for his daughter’s higher education. The goal was 15 years later. His financial advisor created a portfolio of debt, equity and gold funds with an assumed return of 8% in debt, 7% in gold and 12% in equity over the next 15 years. He clearly explained Mr. Jain that the returns are not guaranteed and the portfolio needs regular monitoring. Mr. Jain invested as per the plan.

No more than 6 months later, the equity markets soared. Valuations went up. Mr. Jain investments in equity funds went up by 15% absolute in 6 months. His financial advisor approached with his portfolio and advised him to book profits in equity funds which were giving a yield of 30% pa. ( 15% absolute in 6 months ). His submission was that the returns were much higher than projected and so it made sense to exit now. He suggested re-investing in equity funds when the markets corrected a bit.

Will you approve of the strategy of profit booking in the above case ?

Well, I won’t.

Each situation is different and we cannot generalize what is right and what is wrong when it comes to booking profits or exiting a fund. However, I have the following observations which can be useful before taking a decision.

New Investors

Many investors who have started investing recently ( say 2-5 years ) may not be matured enough to understand and wait for very long term. It may be a good idea to keep booking profits for them at regular intervals to generate their confidence. Once they are used to the volatility and witness medium to long term market cycles, they may be more comfortable for keeping their investments for long term.

Absolute Gain vs Compounded Gains

There is a difference between absolute gain and compounded gains. In the short term, absolute gain should be the parameter to book profits and in the long term compounded gains should be looked into. For eg. 5% gain in a month after investment is made can show a compounded return of 60% pa. But this should not be the rationale for booking profits. A mere 5% absolute return can be too low a figure and at the same time 60% compounding ( based on 1 month return ) is not the best way to judge performance and thereby book profits. A 15% compounded returns over 10 year period is far better than a 20% absolute gains in 6 months.

The argument of ‘No profit booking’

Many advisors have a firm opinion that equities are the best asset class and it gives highest returns over long term. They believe there is no need to book profits.

I won’t agree.

While equities have outperformed most asset class over the long term, it cannot be the only barometer to make investment decisions and booking profits. Several other factors must be considered when it comes to profit booking.

When investment is made for wealth creation – In this case, it may not be necessary to book profits at regular intervals since time horizon is not a concern and the investment portfolio is not earmarked for any particular goal. If the asset allocation is proper, one can continue with equity investments for long term.

When investment is made for goal based need – In this case, it may be prudent to book profits under the following circumstances –

When the equity valuation has exceeded the projected goal value before time and there is a definite need of the funds by the investor for the desired goal for which the investment was made.

When the goal year is just 3-4 years away and there is good rally in the markets and the compounded gains are decent / higher than projected values. It may make sense to book profits and safeguard the portfolio since the next cycle can be pretty long and the investor will need the funds in the goal year.

The investor’s mindset – Some investors may not be comfortable with volatility of equity markets in the initial years of your investing experience. If his equity investment goes up by 80% in 3 years only to drop by 30% in value in the next year, he may be disturbed so much that he may never come back to equity markets ever again.

In this case, it may not be a bad idea to book partial profits at regular intervals. Once the investor becomes seasoned, he can look for longer term holding period.

The case of ‘Frequent profit booking’

While I do not agree with not to book profits ever, I also do not approve of frequent profit bookings. Many advisors promote frequent profit booking with the pretext of making money for clients, assuring that they will buy back at lower levels (timing the market which is very tough). Frequent profit booking increases cost, taxes, risk of losing upside and imbalances asset allocation.

The Psychological way

Generally, it is seen that advisors / investors book profits as per age of asset and profit amount. During a market downturn what is left in the portfolio are recent investments which are in loses or in not so much profits. Clients forget the profits booked earlier and complain of bad performance. Given an option, try to hold on long term folio’s which have accumulated a lot of appreciation and sell medium term folio’s. This way, during bad market conditions, advisors can convince the clients by referring to the long term folio is the portfolio which may still be in decent profits.

Distribution or Reinvestment of Gains

Maintaining AUM is a challenge. Redemption puts a lot of pressure on AUM. As such most advisors suggest investors to transfer principal / gain amount in a debt fund thereby maintaining AUM. Not bad. However, clients look for real money in the bank. Sometime it may be a good idea to redeem some amount and transfer in the bank account. Clients love it. The AUM may drop for a while but mostly it comes back through fresh investments by the same clients.

When to switch / exit an underperforming fund

Like booking profits, an equally important thing is about booking losses or exiting a fund due to under performance. I have the following take on this –

I do not recommend buying a fund on the basis of last 1 year performance. Similarly, I do not suggest exiting a fund on the basis of last 1 year under performance. One should look at longer term track record of the fund.

Again, while looking at 3 year and 5 year performance track record, we should eliminate the recent bad patch of the fund ( say 1 year ) and analyze the performance. This is because the recent bad patch will drag even the medium term performance and can give a wrong signal about compounded returns over medium term.

If the allocation to a particular fund is very low in the total portfolio ( say 2-3% of value ), more time should be given to the scheme to perform. This is because the impact of underperformance will be very minimal in the total portfolio. Having said that, if the outlook of the scheme underlying assets / faith in the fund manager is not looking good, one should immediately exit the fund.

Before exiting / examining the performance of certain sector funds, one should keep two things in mind (1) under performance is because of the overall industry due to bad economic cycle or (2) due to inability of the fund manager ( this can be analyzed by comparing performance within the peer group ). If under performance is due to industry cycle, one needs to decide on the basis of time horizon and outlook of the said industry. If the issue is because of fund manager, one may exit.

If the fund house enjoys good reputation overall, if the scheme has delivered consistent returns over 5-10-15 years, then one should give more time to the fund manager to perform. It may so happen that the market cycle did not impact favorably to some of the calls taken by fund manager in the shorter term of 1-2 years.

Another thing to see if the allocation of underperforming scheme is very high in the total portfolio of the client, than it may be prudent to cut short the exposure and bring it to comfortable levels.

Long story short, unless the outlook of the fund/underlying securities and/or the comfort with the fund manager has gone down, one should wait a little longer before exiting a fund due to underperformance in the short term.

Some other ideas

Never time the markets. Book profits for Rather than selling winners, sell losers. Sell funds which are not performing (when compared to their peers).

Do not try to time the markets in debt markets. It can be more dangerous than equity markets.

Don’t hold bad investments just because you recommended them to clients. Take responsibility. If you think the prospect is not good, exit the fund and acknowledge your mistake.

Finally, I would suggest –

Don’t dominate your clients. Look for their comfort too.

Don’t use your gut feeling. Apply your wisdom.