Managing unrealised gains in your portfolio

Profits not booked carry associated risk. Here’s how this risk can be minimised

Unrealised losses in your core (or goal-based) portfolio can be emotionally stressful. The point is, unrealised gains can cause similar emotions!

Why it’s risky

Suppose you have 20 per cent unrealised gains in your core portfolio. Your investments have to decline by only 17 per cent to wipe out your unrealised gains. On the other hand, if you have 20 per cent unrealised losses, your investments have to increase by 25 per cent to recover the unrealised losses.

You can see that it takes little effort for the market to claw back your unrealised gains, whereas it takes more effort to recover unrealised losses of the same magnitude. This phenomenon is called asymmetric returns effect, and can cause harm to your goal-based portfolio. Why?

Assume, for instance, that you are saving to buy a beach front house 10 years hence. Given the amount you can save every month and the time horizon, suppose your investments have to earn 9.2 per cent compounded annual return for the next 10 years to achieve your goal. This is your minimum acceptable return (MAR). Your risk is that the actual return on your portfolio could be lower than MAR in any year.

But what if you earn a return higher than MAR? Suppose the expected post-tax return on your equity investments is 12 per cent and on bond investments is 5 per cent. Assuming a 60:40 allocation tilted towards equity, your expected portfolio return is 9.2 per cent.

Now, suppose your equity investment in one year earns 15 per cent. Remember, this return is in the form of unrealised gains. Why?

You need the cash flow from your core portfolio only after 10 years, when you have to buy the beachfront house. So, you may want to accumulate the unrealised gains in your portfolio. But that could be risky because the market can claw back your gains. So, what should you do?

Easy to manage

Your bond investments should be in bank fixed deposits, with maturity of the deposit matched to your investment horizon. So, your 10-year life goal to buy a beach-front house should be mapped to a 10-year recurring bank deposit.

This will enable you to set aside money every month from your current income. As interest is the only form of return, the expected return on your bond investment will be equal to your actual return.

The equity investments in your core portfolio should be in index funds. You do not have to diversify across index funds; for all index funds on, say, the Nifty 50 Index, will offer similar returns. Another benefit is that asymmetric returns effect on such investments is relatively easy to manage.

How should you manage the associated risk?

Suppose expected return is 12 per cent whereas unrealised gains in your portfolio are 15 per cent. You should sell only the excess gains over the expected returns on your equity investments. Why? Your MAR is a compounded annual return. This means you need the 12 per cent unrealised gains in your equity portfolio every year. Otherwise, your investment will not accumulate enough wealth for you to buy the beachfront house!

Assuming ₹10 lakh of portfolio value, the equity portion with a 60:40 allocation would be ₹6 lakh. So, you should sell ₹18,000 of index fund units, which is 3 per cent of ₹6 lakh. Because you hold only one index fund, it is easy to sell your investment to moderate asymmetric returns effect.

You should park the sale proceeds in a bank fixed deposit. You will need this buffer money in the years when actual return on your equity investment is lower than expected return.

The writer is founder of Navera Consulting. Send your queries to

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