Some friends called after reading last week’s column. That kind of advice typically lands like a classroom lecture. Those who have been investing in equity for a long period of time will have personal experience to vouch for the simple approach of holding a diversified portfolio that is managed to weed out losers. For everyone else, such advice is simply theory.
This is because they have made their own rules. Everyone who has dabbled in equity investing has had good and bad experiences. They deem these to be their best teachers. The lessons are shared with others, who also draw similar conclusions. The commonality of experience is enough, in many cases, to overtly generalise. Many rules are formed in this manner and usually narrated with great conviction.
This one ranks at the top: one must not be greedy, and one must book profits. This position typically comes from the experience of being with a stock (not portfolio) that ran up in a speculative frenzy, and then crashed. It is also the lesson many investors take from the benefit of hindsight when the equity markets fall. If only I had booked profits, they rue.
Booking profits is similar to playing the market with the mindset of a seeker of assurances and promises. A fixed-income mindset, if you will. There are many errors of judgement that will run along with this need to book profits. The investor somehow believes he can measure the potential of a stock. An equity story is not over until it shows signs of weakness. Money is made by staying with the winners, not by quitting midway because one is feeling uncomfortable.
Why and when is profit booking needed? To get clarity about profit booking, one must see it as an allocation issue or a funding issue. Equity allocation in a portfolio will naturally move up when the markets are bullish, merely from appreciation in value. An investor beginning with 50% in equity will find the allocation at 70% if equity doubles and the remaining 50% earns a small interest. Profits must be booked to return the portfolio to a ratio that is in line with the investor’s risk tolerance.
Profit is booked when new stock shows promise and one needs funds to buy that. Selling an existing winner is one of the ways to raise these funds without allocating new savings to that call. In both these cases, notice that the investor is implementing a view while moving funds from one to another. In the equity world, where no one knows the future, this can work or backfire.The stock from which the profit was booked can run, and the new stock can tank. Every profit booking exercise hopes to be right on both legs, when both directions are unknown. It brings the comfort of holding cash in hand and the satisfaction of action over regret. It is popular for this reason.
To the overall health and return on the portfolio as a whole, profit booking won’t make a difference unless the call is right each and every time on both legs of the decision. Weeding out what is not working satisfactorily is easy, obvious, and helpful. But it is an admission of failure, an act of regret, and investors are not known for selling losing stocks. As I said earlier, investors will see this as a theory.
The second rule I hear is that one must choose well. Any conversation with a selftaught equity investor will bring up stories of multi-baggers that they found and invested in early on. These stories are the reason why investors do not lose interest in equity investing, even if they have a questionable track record of losing money in stocks. They live in the hope of getting it right because the game is essentially one of luck masquerading as a game of skill.
The story of finding tomorrow’s winners today is full of holes. It is mostly told from the benefit of hindsight. Even the professional managers of large portfolios, with access to research and information, do not claim that they always pick the best. They pick stocks based on information and analysis, and they are aware that the story may not play out as envisaged. The most experienced and successful investors are the humblest. They hone their stock-picking skills with time, but they understand that they can’t predict the future. They focus, instead, on monitoring and managing what they have, what they missed, and making decisions about buying, holding and selling.
The real experiences of simple investors playing the equity market and finding a multi-bagger crumbles in one of the following ways. One, they bet too little on that winning stock for its run to matter. Two, they sell it too early, eager to book profits. Three, they use the same tactic to buy some more, which do not play out as expected.
In reality, simple investors do not make a single large bet. Unless they are entrepreneurs investing in their own business that ends up as a unicorn. Or they are senior managers and employees with ESOPs in a hugely successful business. No one admits that these are chance events that cannot be replicated. The stories are so good that everyone gets carried away.
Most retail portfolios tend to have many bets, many stocks, bought and held for various reasons. They dislike admitting it, but they do hold a portfolio of stocks. Sometimes unwieldy with too many stocks, many of these losing value, but not sold. No one asks them to measure the return, or check if they really beat the market index. As long as there is a winner, they feel validated. Every bull market makes gurus out of ordinary folks, who recount stories of their wins. Then the cycle turns and they talk about profit booking.
My list of rules is longer, but I can’t close without this favorite. Buy the business leaders and blue chips, and you just won’t go wrong. Many pride themselves on holding only the best. What they forget is that even this list can’t escape the simple requirement of holding a diversified portfolio and weeding out losers. They must check the stocks in the Nifty when it was created in 1994. Are the leaders of that time still around? Which is the best business is a changing list. Without checking which is not, selling it, and acquiring the one that shows promise, and checking its viability to remain in the portfolio as time unfolds, is an inescapable equity strategy. Yes, I sound like a teacher, and don’t regret it one bit.
(The author is chairperson, Centre for Investment Education and Learning.)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
