We tend to cling to our losses for long but sell winning trades too quickly

If you believe stock picking is difficult, then try taking profits. Knowing when to sell can be more challenging than buying shares. We suffer from what behavioural finance experts call as disposition effect.

It refers to our tendency to hold on to our losses for long but selling our winning trades too quickly.

Opportunity cost

This behavioural bias is a direct application of the loss- aversion effect. We are risk-seeking when faced with losses and risk averse when faced with gains. Can you moderate this bias and fine-tune your profit-taking skills? This week, we discuss how to apply a simple rule to take profits on your existing holdings.

Suppose the stock that you bought some time ago has an unrealised gain of 30%. Should you take profits or continue with the position? Note that our discussion does not relate to your goal-based portfolios, but to your individual stock positions that are part of your trading portfolio. A simple rule that you can apply to take profits is to ask yourself the following questions: How much do you expect to earn if you continue with the position? Are alternative investments available that can provide better returns? Suppose you expect to earn an additional 10% if you continue with your existing position. You spot another investment opportunity that carries a potential return of 15%.

Then, you should switch to the other investment. This rule will not apply if you have enough capital to buy the other investment and your surplus cash is in your savings account.

As you can see, the above argument is based on opportunity cost. Of course, applying this rule is easier said than done.

What if you take profits and switch to another investment only to see the new investment decline and the first investment move up further? Your decision could lead to regret and blur your judgment on subsequent trades. So, what should you do?

Profit-taking rules

You can combine the opportunity cost argument with one of the two methods discussed below for taking profits. The first one requires some understanding of chart analysis while the second one requires more discipline. Consider the first method. Suppose you bought 500 shares of a stock at ₹200 per share. Should you sell your holdings at ₹375 or continue your position? You can take profits on half your holdings (250 shares). You can have a trailing stop loss close to the current price on the remaining shares.

A trailing stop loss works as follows: If the stock moves up, then you continue with the remaining position, moving your stop loss each day as the stock moves up.

If the stock declines, then you should sell at the stop-loss price and exit the position.

You should consider the second method if you are unfamiliar with chart analysis. In this case, after taking profits on half of your holdings, you should determine two price levels.

This could be based on absolute price change (say, 20 points from the current price). The first one is a higher price level to take profits on the remaining position. The second is a lower price level to exit if the stock declines instead.

The challenge is not so much in setting the price levels, but in implementing it!

Conclusion

Taking profits on your existing positions can lead to regret. If you face challenges in taking profits, so do most others. You should consider recruiting a trading buddy till you are emotionally comfortable taking profits on your investments.

You can help your buddy take profits based on his or her rules while your buddy does the same with your holdings. This could work because it is easier to apply profit-taking rules in a disciplined manner for someone else, as you are not emotionally attached to that person’s trade.

(The writer offers training programmes for individuals to manage their personal investments)

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