Profit booking is a common strategy amongst retail investors which involves booking profits to avoid washing out your gains in case of a market reversal. But is this strategy better for investors? Or is the relatively less known loss cutting strategy better for investors? Let’s first understand both of these strategies in detail.
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What is Profit Booking strategy?
Profit booking strategy is a commonly followed strategy where investors book out their profits from their investment positions completely or partially to avoid washing out those profits in case of a market reversal. Depending on the time frame of investment, the investors might get out of their investment after a certain amount of profit (smaller profit for small term investment & larger profit for long term investments).
What is Loss Cutting strategy?
Loss cutting strategy is an uncommon strategy where investors book out their losses after a certain amount of equity is lost. Depending upon the time frame of investment, the investors get out of their investment after a certain amount of loss.
The loss cutting strategy doesn’t involve exiting investment positions when the stock is providing a capital gain. Instead it focuses on exiting the stocks which are providing a capital loss.
Which strategy is better for investors?
The answer might surprise most investors! The better strategy is almost always “Loss Cutting Strategy”. It might seem counterintuitive that a strategy named “Loss cutting strategy” is better than “Profit booking strategy”. Wouldn’t “Profit Booking strategy” provide more profit to the investor? NO!
Loss cutting strategy is almost always better for long term investors in the long run and is a key component for holding onto multibagger stocks.
Comparison between the two strategies
Let’s consider two investors – Ram & Shyam. Ram always follows Profit Booking strategy i.e. he books his profit whenever he gets 50% profit from his investments. On the other hand, Shyam follows Loss Cutting strategy where he books his losses whenever he loses 50% from his investments. Consider their portfolio which contains 5 stocks each – Stock A, Stock B, Stock C, Stock D & Stock E. Both have invested Rs. 20,000 in each stock making their total portfolio value of Rs. 1 Lakh. Here are the 1 year returns from each of these stocks.
Stock A – Became 3 times its current value
Stock B – Became 2 times its current value
Stock C – No Change
Stock D – lost 40% of its current value
Stock E – lost 90% of its current value
Note : These stock returns are intended to mimic a typical portfolio’s returns. You are encouraged to try returns from your own portfolio for a better calculation.
Intuitively, it might seem that Profit Booking strategy should perform better than Loss Cutting strategy. However, the results are exactly opposite! It can be seen that Ram exits his most profitable stocks early leaving him with smaller gains compared to Shyam. However, Ram takes a full loss of even 90% on the stock which crashed. This causes Ram to have a much lower returns (causing him to take an overall loss) because of his Profit Booking strategy. Shyam, on the other hand, enjoyed full returns from his winners while cutting his losers quickly, making him earn a handsome return of 46%!
Why is Loss Cutting strategy better than Profit Booking strategy?
Loss cutting strategy is better than Profit Booking strategy for multiple reasons.
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Avoid big losers
One major component of loss cutting strategy is the ability to remove losing stocks from your portfolio & avoid big losses. Many investors’ capital gets eroded by a few stocks which fall catastrophically from their highs. The reason for the fall doesn’t matter – maybe the promoters committed a scam, maybe the company is from a fading industry or maybe the company made a wrong decision which affected their reputation & business prospects. Regardless of the reason, it is these big losers (some stocks fall over 90% of their all time high value) which typically cause the investors to lose a lot of money in the market. Loss cutting strategy prevents such catastrophes from happening by removing these stocks before they can become a major problem.
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Allows winners to run
There is realistically no limit to the amount of returns which a stock can provide! A stock can fall a maximum of 100% but there is no limit to the heights to which a stock can rise. Loss cutting strategy allows an investor to hold onto their winners for the long term. For most seasoned investors, there are only a few stocks (sometimes just 1 or 2 stocks) which are the cause of their entire wealth! The in-build mechanism of loss cutting strategy filters out bad stocks leaving only such gems which can remain a part of your long term portfolio. To learn more, visit our article – Why ‘average’ thinking doesn’t work in Stock Market?
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Allows multibaggers
For a stock to become 10 times its current value, the stock first needs to rise 2 times its current value. Even before rising to 2 times its current value, the stock first needs to rise 50% from its current value. This simply means that holding onto multibagger stocks requires the investor to hold onto stocks which are already highly profitable. This is the biggest downfall of the profit booking strategy – you cannot have multibaggers if you exit as soon the stock rises 20-30%! However, loss cutting strategy has no limits on holding the stock during their profit.
Even the Nifty 50 index follows Loss Cutting strategy!
Did you know that the most famous index in India (Nifty 50) also follows that loss cutting strategy? Nifty 50 index undergoes a rebalancing every quarter where all the losers are removed from the index & all the upcoming winners are entered into the index. Think about it! The worst performing stocks which have fallen from grace are removed from Nifty 50 whereas new performers which are improving constantly are entering into Nifty 50.
This rebalancing of stocks allows Nifty to have the best chances of capital gain by allowing its winners to run while cutting down on its losers! This is the reason why many multibagger stocks such as Asian Paints, TCS, Infosys, etc. have regularly been part of the Nifty 50 index & bad stocks which erode investor’s capital have been removed every quarter.
Conclusion
Loss Cutting, though less famous, provides much better returns compared to Profit Booking strategy. Loss cutting is synonymous with the virtue of patience which allows an investor to make massive wealth from the stock market. Being patient with winners by putting your unrealized profit at risk can prove to be a massive wealth creator for many investors. However, the final decision of choosing a strategy to follow while investing depends entirely upon the readers!
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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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