What is Profit Booking?
A slang term for selling stocks or mutual funds is “profit-booking.” What it means and how it differs from terminology like redemption and rebalancing confuses a lot of investors. This provides beginners with a basic explanation.
Is it Practically possible?
Let’s use an example to better grasp profit booking. Let’s say you paid Rs. 10 for 100 shares of a company. The sum of the initial investment is Rs. 1000. Several months later, the stock is trading at Rs. 25.55. Thus, Rs. 2555 is the investment’s worth. This is Rs. 1000 plus Rs. 1555 in our minds. Let’s say you want to “book” this Rs. 1555 profit.
As it is not a simple bank account, hence, you can’t get this much money out of it. Some Mutual Fund Units will need to be sold. 1555/25.55 now equals 60.86 shares/ MF units cannot be sold. Either 60 or 61 stocks/ MF Units are required. Mutual funds do provide fractional units for sale, but the reasoning remains the same.
If you sell, 60 shares at 25.55, you get Rs. 1533. Is this a “profit” booking? This Rs. 1533 has two components: (60 x 10) + (60x 15.55). Here 60 x 10 = 600 is the money invested or the principal. The stock price appreciation is Rs. 15.55 and the gain is (60 x 15.55). Thus, every sale or redemption of stocks or mutual funds will always have two components: the principal +/- capital gain or loss.
This idea of Rs. 1000 appreciating to Rs. 2555 and removing Rs. 1555 as “profit” is incorrect mental accounting.
Profit Booking to maintain Asset Allocation:
Now let’s look at another instance of “profit booking,” but this time we’ll do it with a viewpoint toward asset allocation. In other words, we want to allocate 50% of our funds to fixed income and 50% to equities. Every year, we assess the extent of change in this allocation and make necessary adjustments by either booking equity profit and buying more fixed income or, depending on the circumstances, booking fixed income profit and buying more equity.
Let’s look at a portfolio’s growth over five years. To keep things simple, we’ll assume 7% annual return on fixed income and we will exclude taxes and exit loads. We’ll assume the following order of return for equity:
Year | Date | Returns (%) |
1 | 03-04-2000 | 37.07% |
2 | 02-04-2001 | -29.42% |
3 | 01-04-2002 | -1.85% |
4 | 01-04-2003 | -11.98% |
5 | 01-04-2004 | 86.33% |
These are actual Sensex returns. This is the journey that an investor who began investing in April 1999 would have taken. These are selected at random, and as a result, so are the outcomes. The purpose is to demonstrate the “profit booking” concept.
Value Change of Annual Investment
The following chart illustrates the value change of an annual investment of Rs. 1000 for a specific set of yearly returns on debt and equity (fixed income). We begin with 50% fixed income and 50% equities, but you’ll see that the debt asset allocation varies from 43% to 60% due to changes in equity returns.
(Without any rebalancing)
Year | 1 | 2 | 3 | 4 | 5 |
Equity Returns | 37.07% | -29.42% | -1.85% | -11.98% | 86.33% |
Debt Returns | 7% | 7% | 7% | 7% | 7% |
Equity Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Debt Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Equity Value at the end of the year | 1371 | 1673 | 2624 | 3190 | 7807 |
Debt Value at the end of the year | 1070 | 2215 | 3440 | 4751 | 6153 |
Total Portfolio Value | 2441 | 3888 | 6064 | 7940 | 13960 |
Equity Allocation | 56% | 43% | 43% | 40% | 56% |
Debt Allocation | 44% | 57% | 57% | 60% | 44% |
Ideal Allocation |
|||||
Equity Allocation | 50% | 50% | 50% | 50% | 50% |
Debt Allocation | 50% | 50% | 50% | 50% | 50% |
Ideal Equity Value | 1220 | 1944 | 3032 | 3970 | 6980 |
Ideal Debt Value | 1220 | 1944 | 3032 | 3970 | 6980 |
Excess Equity Value | -150 | 271 | 408 | 781 | -827 |
Excess Debt Value | 150 | -271 | -408 | -781 | 827 |
We now want to make sure that 50% of assets are allocated to debt and 50% to equity at the beginning of each year. The invested value at the beginning of the first year was Rs. 1000 in debt and Rs. 1000 in equity. Equity was Rs. 1,371 and debt was Rs. 1070 after the first year.
If we “book profit” (as specified above) of Rs. 150 from equity and invest it in debt, the equity allocation is Rs. 1220 at the beginning of year two (i.e., the end of year one). The debt allocation is likewise Rs. 1220. Due to some “profit booking,” we have now changed the allocation from 56% equity to 50% equity (as decided earlier).
Now what would be the portfolio position, if we annually rebalance the portfolio at the end of the year 2,3,4, & 5?
Year | 1 | 2 | 3 | 4 | 5 |
Equity Returns | 37.07% | -29.42% | -1.85% | -11.98% | 86.33% |
Debt Returns | 7% | 7% | 7% | 7% | 7% |
Equity Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Debt Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Equity Value at the end of the year | 1371 | 1567 | 2916 | 3563 | 9218 |
Debt Value at the end of the year | 1070 | 2376 | 3179 | 4331 | 5293 |
Total Portfolio Value | 2441 | 3943 | 6095 | 7894 | 14511 |
Equity Allocation at year end | 56% | 40% | 48% | 45% | 64% |
Debt Allocation at year end | 44% | 60% | 52% | 55% | 36% |
Equity Value at the beginning | 1000 | 1220 | 1971 | 3048 | 3947 |
Debt Value at the beginning | 1000 | 1220 | 1971 | 3048 | 3947 |
Equity Allocation at the beginning | 50% | 50% | 50% | 50% | 50% |
Debt Allocation at the beginning | 50% | 50% | 50% | 50% | 50% |
Brief
After five years without rebalancing, the portfolio values for this specific example set are Rs. 7807 (in equity) and Rs. 6153 (in debt). This becomes Rs. 5293 (in debt) and Rs. 9218 (in equity) after the yearly rebalancing. It’s easy to see why you ended up with more money overall and in equity. Before that 86% gain in year five, we had around 24% more money in Equity.
At times, regular rebalancing will result in a higher corpus, and sometimes not. Real-time will show the exact figures. However, rebalancing will give you peace of mind. You booked some “profit” after a 37% return after year 1 from equity and you invested that money when you saw a negative 29% return in year 2.
Consider a further scenario in which we only record “profits” if equity returns are positive, very high, or the year-end equity allocation is 5% higher than desired. This will progressively increase the total value of Debt.
For instance, as seen in red at the beginning of year two, we only rebalance in the illustration below if equity returns are positive. Since there is no sixth year in our scenario, we do not take into account a rebalancing after year 5.
Illustration
Year | 1 | 2 | 3 | 4 | 5 |
Equity Returns | 37.07% | -29.42% | -1.85% | -11.98% | 86.33% |
Debt Returns | 7% | 7% | 7% | 7% | 7% |
Equity Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Debt Investment | 1000 | 1000 | 1000 | 1000 | 1000 |
Equity Value at the end of the year | 1371 | 1567 | 2520 | 3098 | 7636 |
Debt Value at the end of the year | 1070 | 2375 | 3612 | 4934 | 6350 |
Equity Allocation at the end of year | 56% | 40% | 41% | 39% | 55% |
Debt Allocation at the end of year | 44% | 60% | 59% | 61% | 45% |
Equity Value at the beginning | 1000 | 1220 | 1567 | 2520 | 3098 |
Debt Value at the beginning | 1000 | 1220 | 2376 | 3612 | 4935 |
Equity Allocation at the beginning | 50% | 50% | 40% | 41% | 39% |
Debt Allocation at the beginning | 50% | 50% | 60% | 59% | 61% |
Brief
This leads to an additional 20% of corpus debt. We are unsure of “which strategy is better” in advance. We cannot find perfect solution to this. However, we may mix one-way and two-way rebalancing for a certain objective.
We first rebalance in both directions. That is, according to the year-end asset allocation, book profit from equity and transfer to debt or vice versa. After a few years, you may concentrate on using one-way rebalancing to progressively increase your debt corpus. You should avoid factoring future income flows now, but you can invest more in equities drops if you have more money from elsewhere.
Lastly, keep in mind that none of the aforementioned examples tries to decrease equity allocation to minimize risk. To guarantee that we reach our target corpus regardless of the state of the market—bull, bear, or range-bound—this is a crucial step. If this isn’t taken into account right once, the amount invested will be less.
Conclusion:
Profit booking is not bad or good. It depends on why you want to book profits. Frequent profit booking will not help you in creating a corpus as it may attract tax, exit load, etc. Further, every time it is not practically possible to catch the top or bottom of the market. Even if the markets are at the bottom, we think that it will fall further and we don’t end up investing more and miss the opportunity.
If you need the money for your goal or your asset allocation is disrupted drastically, profit booking in 3-4 years can be logical.
Remember, the famous American investor Peter Lynch in his book “One Up on Wall Street”, says… “Selling your winners and holding your losers is like cutting the flowers and watering the weeds”.