One of the most investor friendly questions especially when it comes to investment in stock market is
“When should I book profits in stock market”
This article will cover the advantages and disadvantages of partial profit booking in risky assets which are volatile in nature and its results. Deciding to book profits in safer instruments like fixed deposits, PPF, NSC, pension schemes is not that difficult where investment returns are fixed and certain.
Case I – When you are long term investor
What tempt a long term investor to book profits in stock market or mutual funds?
- The general observation in stock markets is when a person invests in mutual funds or direct equities, he is a long term investor, but when he sees 20-30% profit in front of him, he becomes a trader or a short term investor because of the noise in the market and so called Analysts on CNBC asks them to exit and hold cash.
- Secondly, they have a misfortune in the past that whenever you hold their winning positions too long, their investments tend to fall and come at the buying price
All these circumstances make them believe that booking part profits in mutual funds or in stocks is necessary and one need to watch volatile markets constantly and analyse it on the basis of various studies so that they can succeed in timing the markets. Well, is profit booking necessary?
To understand this better, one has to know the difference between income and wealth
The monthly salary which gets credited in your bank account every month is an income whereas the house property which you might be holding is a wealth. There is no compounding (interest on interest) on your income where there is a compounding effect which takes place in case of your wealth i.e house property in this case.
Example: A house property of Rs 10 Lakh today would be worth Rs 40 Lakhs after 10 years assuming 15% return on investment
What I mean to say is booking part profits in stocks or mutual funds create a short term income for you, but when it comes to creating wealth, you can’t afford to book profits as you won’t get a compounding effect on your money as mentioned in the above example
Understanding it with one more example
Suppose you invested Rs 100000 in equity mutual funds and you got 30% return inside 10 months of investments. Your current value of investments turns Rs 1,30,000. Now you have got two options. Either to book profits OR holding on to your winning position.
If you book profits, you are able to book 30% profits which is a short term income. But if you are a long term investor, you may not get 30% in a single year, but in a long run i.e 4 to 5 years, you can expect 18% return in mutual funds, which a lot of mutual funds have given in the past if you are able to monitor your mutual funds on a yearly basis. This 18% returns doesn’t involve the most hectic process of timing the volatile markets. This 18% annualised returns doubles your money in 4 years i.e 100% and makes your money 5 times in 10 years i.e 400% returns in 10 years. The choice is yours.
Case II – When you are a short term investor
But if you are short term investor, then apart from concentrating on capital appreciation, you must also focus on capital preservation. In other words, your game should not get over before it gets started. This step is generally taken when are stock markets are behaving in an uncertain manner as they normally do for most of the time.
Example: Vihaan invested Rs 1,00,000 in HDFC Top 200 Fund and he saw his fund grow by 30% inside 7 months of investment. Now after running Rs 30000 i.e 30% in profits which is yet to be booked, he is not sure of whether his mutual fund would perform positively or negatively in future. Now he can manage his funds in two different styles
Case II (A) – If he book partial profit in stock market
When it comes to partial profit booking, I am assuming 50% of the stock profits to be booked and rest to remain invested. Now his Rs 1,00,000 of investments grew to Rs 130000. He books 50% profits by withdrawing Rs 65,000 and kept the remaining part of Rs 65,000 invested in a mutual fund scheme.
If he gains further in future:
- His mutual fund goes up by 25% in future
- His profit from his remaining investment of Rs 65000 would be Rs 16,250
- His total investment of Rs 100000 becomes Rs 146,250 (100000 + 30000 + 16250)
If he losses in future:
- His investment in HDFC Top 200 fund falls by 25%
- His loss from his remaining investment of Rs 65,000 would be Rs 16,250
- His total investment of Rs 100000 becomes Rs 1,13,750 (100000 + 30000 – 16250) which makes his original investment still running in profit by 13.75%
This means by booking 50% of his profits, his maximum profit became +46.25% and minimum profit comes at 13.75% assuming an increase/decrease of 25% in the fund performance thereafter.
Case II (B) – If he doesn’t book profit in stock market
Now, this is the time when he opts not to book any profit. Let’s have a look at his risk to reward ratio in this case. Assuming his original investment of Rs 100000 has already grown to Rs 1,30,000 as per the last case discussed.
If he gains further in future:
- He further gains 25% on his investments after already gaining 30% initially
- Further gains of 25% means he gained Rs 32,500 more (25% of Rs 1,30,000)
- His investment of Rs 1,00,000 would result in Rs 1,62,500 (100000 + 30000 + 32500), a total net profit of 62.5%
If he losses in future:
- He losses 25% on his investment, which earlier gained 30% returns and turned Rs 1,30,000
- Loss of 25% means he lost Rs 32,500 more (25% of Rs 1,30,000)
- His initial investment of Rs 100000 would become Rs 97,500 which is at Rs 2500 loss as compared to original investment made
This means by not booking partial profits, he is open to make losses upto an extent to -2.5% and make a maximum profit of 62.5% assuming a increase/decrease of 25% in performance of stock investment in future
Booking partial profits and not booking profits are two different ways of participating in equity markets. The former is called an investor whereas the latter one is termed as trader cum investor. If you can’t track the markets, opt to become an investor in mutual funds rather than direct equity, but if you are expert at timing the market or want to make quick bucks, the latter option might do wonders for you and your portfolio. Because, if your investments start to fall after gaining profits, that can be compensated by earlier gained profits in the investment. It also depends on your risk appetite as to how much loss you can afford to bear.