Equity investing: Should you book profits or continue investing?

It is essential to hold on to good quality stocks for longer periods to make significant profits.

As most of the economic indicators are giving positive signals and the country’s stock market indices are touching life-time highs on a daily basis, often investors are worried about the most important question: whether they should continue to invest or book profit. According to the investment science literature, to participate in wealth creation, it is important for investors to remain invested and continue to invest systematically irrespective of the fact whether Sensex crosses 62,000 or not.

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How about valuation?
In spite of the Covid-19 times, the stock market not only recovered but also rallied significantly higher. A large number of investors have benefitted owing to this remarkable rally but many are wondering about elevated levels of valuation. Current market cap-to-GDP ratio is 127 whereas the long-term average is around 78. Similarly, Nifty’s one year forward P/E ratio is 23 times but long-term average is 16 times.

Apart from the above, other parameters such as dividend yield, price-to-book ratio, etc., indicate that markets are at elevated valuations. As investors’ portfolios have gained a lot, the question is that is it the time to book profit. Well, the answer for this question depends on various parameters and financial goals of each investor.

Remain invested to create wealth

It is empirically proven many times that the biggest wealth creation in history always happened through the stock market. So, if your goal is wealth creation, by participating in the stock market, then the strategy should be to remain invested and continue to invest systematically. It is essential to hold on to good quality stocks for longer periods to make significant profits.

Reduce overall portfolio risk
It is evident from various parameters that valuations are rich and the market may be vulnerable to sharp corrections. So, investors can reduce their overall portfolio risk by selling high beta stocks and mid and small cap shares because these have high impact owing to market volatility. Another way of reducing portfolio risk is investing into safe, high quality defensive stocks in sectors such as FMCG, pharmaceuticals, etc. One can also think of setting aside some part of investment in fixed income instruments such as highly rated corporate bonds. Equity mutual fund holders could think of re-allocating part of their investments towards hybrid funds.

Riding the rally with caution
In FY21, around 14.2 million new demat accounts were opened and a significant percentage of these accounts were opened by retail investors. Similarly, inflows into mutual funds are also quite high. Buoyant GST and other tax collections, growth in exports, and sustained earnings in selected sectors indicate that the market may remain resilient in spite of the stretched valuations. However, corrections might happen at any time as valuations are stretched.

To conclude, the plausible reason for the stretched valuation is injection of liquidity by various financial institutions across the world. The road ahead is certainly bumpy but investors should ride with caution.

The writer is a professor of finance & accounting, IIM Tiruchirappalli