When to book profits in your investments?

A lot of mutual funds and stocks have doubled based on the last 1-year performance. Stock markets keep making highs, but the broader economy is still struggling to come back to full
force. As a result, lockdowns are still enforced, and there is a general worry of a third wave.

In this background - there are two sets of investors. One set wants to book profits for fear of loss due to an overpriced stock market. On the other end - there are a massive number of
investors waiting to enter at lower levels.

Let’s focus on the first set. Should investors book profits now? If not now, then when? Economy and markets may not be linked - Investors fearing the macro-climate should remember that often the economy and stock markets are not linked. Markets are usually forward-looking and are built on expectations as opposed to reality. For example - the US stock markets recovered in 2009, whereas the economy recovered sometime in 2011 from the financial crisis. Therefore blaming the economy may not be worthwhile.

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Re-invesment risk - Investors wanting to book profits usually don’t think about where to invest the money post profit booking. Money invested in markets is a lesser headache than money lying in a bank account. Therefore, unless investors are sure of where to invest the proceeds, they should not book profits.

Buying at lower levels - Investors may be tempted to time the markets by selling high and buying when markets are at lower levels. Unfortunately, countless studies have shown that it is merely impossible to time markets. Investors who book profits might have to wait for months, maybe even a year or two, to enter at lower levels. Almost nobody in history has managed to consistently been able to time markets - so be careful when you listen to stock market pundits who advise on market timing strategies.

So when should an investor book profits or sell their mutual funds portfolios? There are two excellent reasons.

1) Achievement of financial goals: Goal-based investing is one of the best long-term investing methods. It keeps investors disciplined, focused and ensures a savings mentality. When investors invest for specific financial goals like a car, house, kid’s education, and retirement - it is prudent to sell investments once the goals are realised. Investors should keep in mind the tax consequences of selling mutual funds before realising funds to pay for their goals.

2) Rebalancing portfolio: Apart from goal-based investing, which requires investing in a disciplined way for many years, another important step is rebalancing portfolios periodically.

What is rebalancing?

Supposed the investor is investing 60% of their savings in equity and the rest in debt. Over the years - the equity portion will increase at a faster rate than debt investments. In this scenario, it is prudent for investors to sell equity investors and re-invest in debt funds. Without rebalancing - an investor’s portfolio gets riskier every passing year. On the other end - a crash in the stock market is where investors can use rebalancing to increase equity allocation by buying at low prices. If done right - rebalancing ensures investors are constantly buying low and selling high.

In conclusion, the reason to sell equity investments is either to realise a financial goal or to rebalance portfolios. Any other reason apart from these two will possibly cause more harm than good to your long-term investments returns.