Steps to Take Prior to Cashing Out Your Investment Portfolio
Investing in mutual funds can be a wise decision for many, offering the potential for substantial returns. However, premature redemption can have significant adverse effects on an investor's returns, as demonstrated by various scenarios.
In Scenario 1, an investor who started with a SIP of Rs 1,000 in BSE Sensex in January 2005 and stopped in April 2005 missed out on potential gains due to a minor fluctuation in the value of their investments. This instance highlights the importance of staying invested for the long term.
Similarly, in Scenario 2, an investor who started monthly SIP of Rs 1,000 in BSE Sensex from January 2005 to December 2009, and stopped in February 2008, missed out on potential gains due to the subsequent market recovery. Panicking due to sustained loss can also lead to missed opportunities, as shown in a hypothetical example where the value of SIP investments dipped below the invested sums between October 2008 and March 2009, but recovered thereafter.
One of the main disadvantages of premature redemption is the imposition of exit load charges. Most mutual funds impose an exit load, a fee charged when investors redeem units before a stipulated minimum holding period (often 1 year for equity funds). This reduces the redemption amount and directly lowers returns.
Premature redemption also leads to higher tax liability. Gains from equity funds held under one year are taxed at a higher short-term capital gains rate, whereas holdings beyond one year qualify for the lower long-term capital gains tax. This increases tax outflows and reduces net returns.
Moreover, early redemption interrupts the power of compounding returns, which benefits investors who remain invested over longer periods. This reduced compounding effect can significantly impact wealth accumulation over time.
In certain schemes, premature redemption can also result in the loss of claimed tax deductions, turning gains into taxable income and negatively affecting overall returns. Some funds, such as ELSS (Equity Linked Saving Schemes), have mandatory lock-in periods (e.g., 3 years). Premature redemption before this period not only attracts penalties but also results in the loss of claimed tax deductions.
Large-scale premature redemptions can also force the fund to sell securities at unfavorable times, potentially harming the fund's performance and, indirectly, all investors in the fund. Exit loads aim to mitigate these effects by discouraging frequent or early withdrawals.
Investing in mutual funds for the long term, especially through Systematic Investment Plans (SIPs), can yield better returns due to the averaging effect. By staying invested and avoiding premature redemption, investors can reap the benefits of compounding, lower taxes, and the potential for higher returns. It is, therefore, advisable to consider the long-term consequences of premature redemption and make redemptions only when necessary or when there is a clear sign on why to exit the investment.
[1] Investopedia. (2021). Exit Load. Retrieved from https://www.investopedia.com/terms/e/exitload.asp [2] Cleartax. (2021). Tax on Capital Gains. Retrieved from https://www.cleartax.in/s/tax-on-capital-gains [3] Investopedia. (2021). Mutual Fund Exit Load. Retrieved from https://www.investopedia.com/terms/m/mutualfundexitload.asp [4] Cleartax. (2021). Tax Deduction Under 80C. Retrieved from https://www.cleartax.in/s/tax-deduction-under-80c [5] Cleartax. (2021). ELSS Taxation. Retrieved from https://www.cleartax.in/s/elss-taxation
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