Investors are always in a dilemma between short term profits vs long term gains. The volatility of the stock market which makes many people believe that regular profit booking is the best solution. On the other hand, there are many people who believe that investing for the long term is the only way to create big wealth because the market goes up in the long term. So, which one is true? What should retail investors do? The short answer is – an investor should do both profit booking & long term investing. Before we look into how investors can do both, let’s look at the benefits of both strategies.
Advantages & disadvantages of regular profit booking
Profit booking refers to the strategy of selling a stock after their price has increased, hoping for the eventual fall in the stock price. This strategy aims at capturing the short term volatility of the stock with the idea of reinvesting in the stock again at lower prices.
Advantage
Regular profit booking is mainly a trader’s strategy, although it can be used by investors as well. Regularly booking short term profits can allow investors to take advantage of the volatility of the stock market. Buying a stock near its major support and exiting the stock after a rally to make a short term profit can be a lucrative idea for an investor in the short term. This strategy works well especially in a volatile market. However, booking profits in a very short term (intraday or in a few days) is generally inefficient because the low profit made in the trade gets eaten away by commissions & brokerage. So, investors should only focus on profit booking on a medium term (few weeks to few months) if they choose to follow this strategy.
This strategy can be a good strategy when used in moderation because it reduces the investor’s exposure to the stock market. It also allows investors to exit stocks during good times, securing their profit which can be used to reinvest in the stock market during a downfall. This strategy tends to work well during a choppy market i.e. when the stock market is range bound & is not in a clear trend.
Disadvantage
The biggest disadvantages of this strategy is that you will miss out on every single multibagger stock! Consider a stock such as Avenue supermart (Dmart) which has risen from its IPO listing price of around Rs. 600 in 2017 to the current price of around Rs. 4000 today. A similar story has happened in Deepak Nitrite which has seen a rise in stock price from around Rs. 100 in 2017 to around Rs. 2200 today. Imagine if an investor decided to book profits in such stocks, they would not have received any other opportunities to accumulate these stocks again! The only way to enjoy multibagger returns is to hold the stock regardless of the volatility.
The profit booking strategy absolutely fails when the stock markets are trendy i.e. the market is in a clear up-trend or down-trend. Investors book profits in the hopes of buying the stocks at a lower price, only to find out that the stocks never come back to their old prices. Imagine being an investor who exited after the biggest 6 month rally in Nifty which followed the Coronavirus crash of 2020.
It might have seemed like a smart decision to exit after a 50% rally in the Nifty index. But in hindsight, that investor missed out on the biggest gains which the stock market has provided in following months with no opportunity to re-enter! Exiting after the first rally made the investor miss out on the entire second rally.
What should investors do?
The best strategy is to do both – regular profit booking in a small portion of the portfolio while staying invested for the long term. Here is a guide which retail investors can follow.
- There is no good reason to restrict yourselves to only short term or long term investments. An investor should focus on both focusing more towards the goal of wealth creation. To learn more on if you should invest, trade or do both, visit this article!
- Have a short term portfolio (15-20%) and a long term portfolio (80-85%). The short term portfolio should contain momentum stocks or swing trades in which the investor plans to book profits. Long term portfolio is the wealth creation tool for the investor which should not be sold to capture small profits.
- Never exit a stock completely after a rally. Partial profit booking allows investors to reduce their risk while staying invested for the long term.
- Always have a long term vision. The stock markets have a correction almost every 6 months & have a crash almost every 8-10 years. Despite countless corrections & crashes, the Nifty index has risen from 1100 points in the year 2001 to around 17000 points in the year 2022 rewarding all the patient investors.
However, the final decision on the investment strategy depends on the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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