Idea Of The Week: Here’s What You Can Do To Lock In Investment Profits [16 Jun 17]

Consider this: one the investments in your portfolio has done superbly well, with its price appreciation so rapid that valuation levels have become excessive. Instead of heading for the exits, you hold on to the investment in hopes of further gains, only for prices to come crashing down to where you started from. Your total investment return? Zilch. This scenario does not belong only in the realms of our imaginations. In fact, we've all been there – a crossroad in our financial journey where we are faced with the dilemma of selling or holding on to a winning investment. While buy recommendations are prevalent, few offer much advice when it comes to taking money off the table.

Importance Of An Exit Strategy

Knowing when to lock-in your investment profits is arguably as important as your market entry strategy because there is no telling when the next market crash is going to take place. Back in 2000, before the market downturn that eventually precipitated, not only did investors pour increasing amounts of money into equity mutual funds, they did so at a record pace of USD 316 billion net inflows. Investors only pulled money out of the market towards the end of the downturn in 2002 (Chart 1). The same pattern was also observed in the global financial crisis that took place over 2007 – 2009.

Chart 1: Investors Typically Invest More Closer To Market Tops

Investor sentiment is typically at its most bullish in times of strong market rallies. Enticed by the prospect of greater returns, investors can sometimes let greed cloud their investment judgment, pouring increasing amounts of money into the market as their confidence grows. However, rallies don't last forever, and as the old Wall Street saying goes, no one rings a bell at the top. When financial markets turn sour, especially when it happens faster than most investors realise, the paper profits that have piled up during the long market rally can suddenly turn into losses, at which time most investors promptly head for the exits out of fear. As such, the absence of an exit strategy is one of the surest ways to lose money in investing.

Profit Taking - When, Where And How?

Investors should consider locking in some profits when an investment experiences rapid price appreciation above its fair value. The US equity market, for instance, has continued to record newer highs over the past few quarters. Investors who have US equity exposure in their portfolios have as a result, benefited from the handsome gains that the market has delivered. However, with the S&P 500 Index trading above its fair value of 15.0X at 18.7X and 16.7X based on 2017 and 2018 estimated earnings respectively (as of 15 June 2017), it may be feasible at this juncture to reduce exposure to the US equity market and re-deploy cash into other markets which are more attractive.

Similarly, the European equity market has rallied strongly by 10.5% year-to-date (total returns in SGD terms as of 15 June 2017) in light of improvements in economic momentum across Eurozone, with valuations creeping up and looking stretched at the moment. The Stoxx 600 Index is currently trading at PE ratios of 16.0X and 14.6X based on 2017 and 2018 estimated earnings respectively, representing a premium above its fair PE ratio of 13.5X.

Investors can exit an investment by realising their profits in one fell swoop, selling their entire investment holdings. While this method ensures that they end up with positive gains, premature exits can sometimes be costly as it is entirely possible for overvalued markets to continue rising, such as the S&P 500 Index, with investors missing out on the potential profits had they stayed invested. A better way to exit would be to take profits in small amounts regularly over an extended period of time, much like a dollar-cost averaging strategy. This allows investors to lock in some profits on their winning investments, and at the same time, continue participating in the market should there be a prolonged rally.

Now What?

Heading to the banks to deposit your investment profits right away is another sure-fire way to lose money in investing, with inflation silently eating away at the value of your cash savings as the paltry interest rates offered by most savings accounts have been unable to keep pace with inflation. By not re-investing your profits, you are also missing out on an opportunity to get potentially better returns. At this juncture, investors can consider shifting some of their developed markets exposure to Asia and emerging equity markets, although the latter group has also staged a strong showing this year, as reflected in our star ratings adjustment for these markets. Despite the rally, Asia and emerging equity markets remain attractively valued, and investors can consider deploying some of their profits into our recommended funds such as the popular First State Dividend Advantage and the Wells Fargo EM Equity Income A USD Acc.

If investors wish to remain invested in the developed markets, they can consider re-deploying some of their profits into more defensive equity funds within the respective overvalued equity markets. For the US equity market, investors can consider the Neuberger Berman US Long Short Eqty A1 USD Acc, which employs a long-short strategy that seeks to profit from both rising and falling equity prices by taking long and synthetic short positions. The more defensively positioned Henderson Hzn Pan Eur Alp A2 EUR could be an alternative for investors looking to stay invested in the European equity market.

Investors can also look to insulate themselves from any market pull-backs by slowly shifting their profits into short duration bond funds, such as the Nikko AM Shenton ShortTerm Bond(S$) or the United SGD Fund Cl A Acc SGD. They are terrific safe havens when the equity market is extremely volatile as they are considered to be less risky than their equity and bond counterparts. Short duration bond funds typically invest in short-term fixed income instruments that typically mature in two to three months. While short duration bond funds tend to generate stable but low single-digit returns, they protect investors from excessive losses during down cycles and are better than the interest rates offered by most savings accounts in Singapore. Furthermore, short duration bond funds are very liquid, which means that investors can sell their holdings with ease and redeploy their cash into other markets should opportunities arise.

The Research Team is part of iFAST Financial Pte Ltd.