Partial Profit Booking Erases Risk Factor

The principal reason of investing in equity is simply to make profits. However, a majority of investors fall prey to one of the basic human follies in their desperation to maximise profits: greed. Investors downplay the risks associated when investing in equities and end up losing almost all of their investments most of the time.

The main objective while investing in equity is to preserve one's capital first before thinking about making profits. Investing without paying heed to capital preservation leads to losses, as an investor will be desperate to recover both his lost capital and booking profits at the same time. When an investor realises some profit from his investments but is unsure as to what the future will yield, he can book only a part of the profit to minimise risk. The objective of doing so is to ensure that some of the profit is already in hand and the money available for investment is risk capital, or an amount he can afford to lose.

For example, an investor who has invested Rs 1,00,000 in shares sees they have grown by 20% in six months. However, now he finds that the markets have turned increasingly volatile and he can either make 40% more profits or lose 40% at once. What are the options then?

Option 1

Not booking partial profits: Let us assume that an investor's investments have grown to Rs 1,20,000 and if he does not book any profits, he can either gain or lose 40%. If luck favours him and he does make a profit of 40%, he will get Rs 1,20,000 x (1 +.4) or Rs 1,92,000. But if he incurs a loss of 40%, he will get Rs 1,20,000 x (1 – .4) or Rs 72,000. His total investment had been Rs 1,00,000 and the odds are that the returns can either be in the range of a 92% profit or a loss of 28%.

Option 2

Booking partial profits: Suppose an investor decides to book 50% of the profits. This means he will book Rs 10,000 of his investments which have grown to Rs 1,20,000. Hence, he will receive Rs 60,000 as profit while the remaining Rs 60,000 still invested. If he makes a profit of 40%, the investor will get Rs 60,000 x (1 +.4) or Rs 96,000. If there is a loss of 40%, he will get Rs 60,000 x (1 – .4) or Rs 36,000. As he has already received Rs 60,000 earlier, the actual range of profit or loss, he will realise that he will get Rs 1,56,000 or Rs 96,000, respectively. This means that the investor will either make a profit of 56% or lose 4% eventually.

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