The illusion of “profit booking”

Most portfolios were down quite a bit since end of August and a common regret among most investors was that they should have booked “some profits” while the going was good.

Dec 07, 2018 04:12 IST India Infoline News Service

Most portfolios were down quite a bit since end of August and a common regret among most investors was that they should have booked “some profits” while the going was good.
 
Consider a portfolio of Rs100 which was up 35% for the year and was trading at a value of 135. A sharp fall in the markets brings down the portfolio value to 100.
 
Now assume there is a brilliant investor who did book his/her profit of 35% before the fall.
 
Quick quiz, that you need to answer in ten seconds. In terms of % how much is this investor better off from the lay person who did not book their profit?
 
Psychologically most of us will anchor to the 35% profit and believe that the investor would have probably saved close to 35%. If not 35%, one will tend to believe that the smart investor would have definitely saved quite a bit by selling before the large fall from 135 to 100.
 
Now that you have your quick answer, let’s look at the math.

Predicting a 26% fall perfectly from the top and taking 35% gains off the table, leaves you better off by 9%.
 
If your account for the fact typically even a good timer will not perfectly time the top and bottom and may be off by a bit i.e. he/she may sell closer to 130 and buy back when the portfolio is closer to 110, the investor will probably be better off only by 4–5%.
 
This wasn’t immediately clear to me and i am sure it isn’t to many investors who use mental short-cuts to arrive at conclusions.
 
Attempting to book your profits when you are up 35% and buying it back post a 26% fall in the market may seem like a big money-saver but it isn’t even close, especially if you consider the slippage from top and bottom, the emotional roller-coaster, transaction costs and taxes.
 
The point of this article is not to say that the 5% that a decent market timer saved doesn’t matter (it’s great if someone can do that consistently), but that we often in our heads think that the we could have saved a whole lot by timing these crests and troughs, which may not be all that true.
 
If you’re curious, the only way to have “saved the full 35%” was to sell 100% of your portfolio — something most of us wouldn’t ordinarily do.
 
The author, Prabhakar Kudva is Co-Founder and Director of Samvitti Capital.

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