Take profits to moderate emotions

This column dated December 18, 2011 discussed the importance of staying invested in the equity market during downturns as well. We followed the discussion last week by explaining how to create a rule-based approach to investing.

We continue this discussion thread, as the topic seems to have triggered considerable reader response. Of interest is the question: Should investors take profits and move out of the equity market when valuations are stretched?

This article explains investor behaviour with respect to gains and losses. It then shows why it is difficult for investors to take profits and avoid sharp declines in asset prices.

Asymmetric behaviour

Individual's behaviour towards gains and losses is well documented. Behavioural finance suggests that the pain suffered due to losses is much more than the joy derived from gains. That is, the pain of losing Rs 2 lakh will be much more than the joy of winning Rs 2 lakh! This tendency, termed as loss aversion in behavioural finance, has far-reaching applications for individuals. How?

Suppose an investor has unrealized gains of 8 per cent in her equity portfolio. The question arises as to whether to take profits or stay invested. There are risks associated with both decisions.

An individual can take profits only to see the asset prices climb up further. Or the individual can stay invested but could suffer losses if asset prices reverse. And unless the individual has a longer time horizon, the sharp loss in asset prices in the near term could severely hurt portfolio value, not to mention the risk of failing to reach the investment objectives.

Based on the loss aversion effect, however, the decision to take profits seems obvious. The investor would rather protect her downside risk and give-up some upside gains in the process than wait for some upside gains and in the process suffer losses. This does prima facie contradict with our suggestion that individuals should stay invested in the equity market during downturns as well. So, allow us to explain.

What downside?

Equity risk premium- the premium that individuals demand over the risk-free asset to invest in equity- is a function of asset price levels. The risk premium is high during a downtrend and low during an uptrend. This is the same as saying that individuals perceive high risk when the market is trending down and low risk when the market is trending up.

The perception of low risk during an uptrend means that the investors typically fail to move out of the market when valuations are stretched. And for those who do take profits, it is moot if they adopt a disciplined approach to staying out of the market till valuations have fallen to comfortable levels.

Our experience has shown that individuals who do take profits typically invest the amount back into the market too soon, and lose the entire profits, if not the capital! And once they suffer losses, regret aversion kicks-in, making it difficult for them emotionally and otherwise to get back into the market.

This behaviour significantly hurts portfolio returns. Why? Empirical evidence suggests that “missing” the ten best days can reduce annualized returns by 50 per cent and “avoiding” the ten worst days can improve returns by 50 per cent. Since investors cannot easily “avoid” the ten worst days or catch the ten best days, we suggest that they stay invested in the market through their investment horizon.

Conclusion

Behavioural finance states that investors will give-up gains to avoid losses. But investors do not typically feel the pain… until their profitable investments turn losses. And selling equity after sharp decline erodes portfolio value, not to mention the missed opportunity to claw back losses; for the odds of the market climbing up after a crash is high.

True, it is optimal to take profits before a market crash and patiently wait for the prices to climb up before reinvesting. But that is easier said than done.

It is optimal to adopt a rule-based approach to investing and taking profits to moderate emotions.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com )

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