Profit calculator: Calculate when you should really book profits

Asset allocation is the cornerstone for constructing portfolios mainly because of the discipline that is built into this process of managing wealth. Asset allocation comprises of 2 parts: strategic and tactical.  The former consists of a divisional split of wealth on the basis of thought-out long term goals (which spells out return expectations) and risk mentality (which spells out the willingness to bear risky assets). 

Asset Allocation

If long term goals are fairly ambitious in nature be it either via a desire of elevated returns or a short time horizon then the strategic asset allocation would tilt towards assets offering scope for stronger appreciation. 

Portfolio Risk and Reward Analysis

At the cost of this however, portfolio risk could increase and thus a trade-off between risk and return commensurate with the investor’s risk return profile should be maintained. Hence, before freezing strategic asset allocation the investor’s frame of mind with respect to volatility of returns should be understood via a questionnaire or any appropriate tool to gauge his/her gumption for risk and return.

Profit Calculator

Once the strategic asset allocation is decided, periodically the investor should capitalize on, or take advantage of, market movement and shift allocations tactically towards undervalued assets or those which offer conviction of sustained momentum in the foreseeable near term. 

So in this process of shifting allocations towards attractive assets the investor could choose to either book profits prudently in those assets that have already appreciated towards their intrinsic value or could rotate out of those assets where the seasonality or cyclicality is waning or simply cut losses in those assets where there is a rational case for further value erosion – either due to macro headwinds or bottom-up fundamental concerns.

Emergency Liquidation of Securities

Another instance for deviating from strategic asset allocation would be the rare instance when the investor would have an urgent requirement of liquidation of securities to meet emergency or distress needs. In such cases, one could look to minimize tax outgo and hence sell off those assets where there are either minimal gains or those in losses. On the other hand, should one have a reasonable basis for booking profits in light of impending negativity around a particular asset, that could also be trimmed down or exited to generate cash flows.

Misguided Approach

Net-net, tweaking portfolio weights with the goal of hovering around the strategic asset allocation offers a structured process in conjunction with bottom-up fundamental analysis for deciding any intermittent profit or loss booking. Most investors focus entirely on never-ending security selection rather than asset allocation to produce better portfolio outcomes. Empirical evidence shows this approach is misguided. The opportunity to produce differentiated performance is much greater from active asset allocation than from active security selection.

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“The equal importance of asset allocation and active management” by James X. Xiong, Roger G. Ibbotson, Thomas M. Idzorek, and Peng Chen (2010), for instance states that standalone asset allocation accounts for as high as 50% of returns, standalone security selection only around 40% and the rest by the interaction effect between the two.

By Rajesh Cheruvu, CIO, Validus Wealth