Wednesday, June 6, 2012

Why you need an exit plan for investments.

N Shrijith, a marketing professional with a multinational spirits company, had plans to buy a house in 2012. For this, he started investing in equity mutual funds in 2005. However, his hopes were dashed when he checked his investment last year. 

To his dismay he found that the value of his investment had eroded drastically with the fading fortunes of the stock market. Shrijith had no other option but to put his house purchase plans on the backburner. 

"Had he planned an exit strategy well, his dreams would have come true," says Abhishek Gupta, CEO,Moat Wealth Advisors. On many occasions, market volatility kills individual's plan. "Such instances are commonplace with people investing in risky assets, such as equities. In any investment, a planned exit is as important as a well thought out entry," he adds. 

Consider the perilous scenario of someone who has been saving for his retirement for the past 20 years, with a substantial allocation to equities. Without doubt, the person would have accumulated a substantial kitty by now, right? But he also would have lost a good amount of money in the current downtrend in the stock market. 

In hindsight, the best strategy would have been selling off the equity investments in January 2008 and moving all proceeds into debt. But that amounts to day dreaming. "Either you have to be god or you have to be plain lucky to sell all your equities at the top," says a wealth manager. 

There is no magic wand to tell you that you have reached the top or the market is going into a lean phase. Missing the top is something you can live with. But what about the other way round? Selling all your equity holdings at the bottom is worse. Again we cannot pinpoint the bottom so that we can avoid it. 

Consider the month of May 2012. The first quarter results could not attract much investor interest, rather many companies could not deliver what they promised. The macro economic scenario is not encouraging, too, with quarterly GDP growth falling to nine year low at 5.3% and inflation threatening to make a strong come back. 

The market benchmark S&P CNX Nifty lost 6% in the month of May. This is an extremely pessimistic environment for equities. Being forced to sell at this time would be the last thing that one wants. The worst is: no one knows when the sentiment would improve going forward. 

"The best option left with small investors is to gradually move their money from risky assets to safer assets as they move closer to their goals," says Mukund Seshadri, founder partner, MS Ventures Financial Planners. And he is not alone. 

"If you gradually move your money from equities to debt over a period of time, you reduce the timing risk of selling at the market trough," says Uday Dhoot, deputy chief executive officer, International Money Matters

Say, for instance, if you are retiring today, you should have ideally started moving your money from equities to debt from June 2010. Three years prior to your goal, you should move 33% of your equity allocation to debt, two year prior to your goal the next 33% and one year prior to your goal date the remaining equity investments should start moving into safer avenues. 

In other words, if you are retiring in three years from now, start today. If you are a mutual fund investor, you may choose to use a systematic transfer plan from your diversified equity fund to a short-term bond fund. You can also choose to gradually sell investments in gold, since gold too has seen much volatility. 

This strategy need not guarantee you an exit at the top, but will save you selling at the bottom. The idea is to reduce the exposure to volatile assets gradually and building a portfolio of safe assets, which you can hold comfortably. 

If you are of the opinion that interest rates may climb from here, do not invest your sell proceeds in long-term bond funds. Short-term bond funds, liquid funds and fixed deposits with nationalised banks are some conservative investments. 

"But keep an eye on the tax angle while moving from one asset class to another," says Uday Dhoot. This is especially true if you are an active investor and have some tactical allocations to volatile assets. In case of equities, gains on investments for more than one year are considered to be long-term capital gains and are not taxed. 
But short-term capital gains are taxed at 15.45%. The tax angle can materially impact your realised returns. In case of fixed income investments, short-term capital gains are taxed at the marginal rate, whereas long-term capital gains are taxed at lower of 20.6% with indexation or 10.3% without indexation. 

In both - equities and fixed income - the timing of selling can materially influence the returns. It pays to keep track of your portfolio performance and move money from risky assets to safer avenues over a period of time so that your dreams don't remain only on paper.


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