The Booking Profits Fallacy
Ever since I started working with Happyness Factory, some of my friends have been very unhappy with me, because I have steadfastly refused to give them any “tips” about “investments”! Their expectation is that since Happyness Factory is an “investment company” (their words not mine), I must have investment tips to offer. No amount of my explaining that we ‘manage investors’, ‘not investments’, has been sufficient to register the difference between these two phrases. BUT that’s a discussion for another time. In any case, “tips” is not how one should be planning one’s investment strategies even if the tips are from Warren Buffet.
That expectation, however, often leads to some very interesting (and instructive, at least for me) discussions. A few months back, a friend asked me a fecund question. She had recently retired and at that time, as part of her final settlement she had received a generous sum of money – gratuity, leave encashment etc., which she had invested in a good set of mutual funds. At the time this discussion took place, the Sensex had steadily come down to somewhere between 57000 and 58000 level after having crossed 60000 a few days prior to that.
So, her question was – “Should I redeem my investments in these mutual funds?”.
The conversation went as follows (words in italics and bold are mine, others are hers)
“Why are you thinking of redeeming?” I asked.
“From the time I invested the value has appreciated by about 35%. So, I can make a good profit if I redeem now” – She said.
“But what would you do with that profit?” I asked again.
“Invest it again” – Was her reply.
“But it is already invested. So why take it out, pay capital gains tax and invest it right back?” Was my question.
“But what if the market falls further? It has already fallen by about 5% in the last 2 weeks, I have already therefore lost a couple of lakhs of rupees. What if it falls further? I will only lose more.”
“And what if the market goes up and does not fall? Would you then not make even more money than what you have made till date? In any case, since you don’t intend to leave that cash in your savings account but invest it right back, the fall or rise of the markets will affect you in exactly the same way anyway.”
“If you need the money to spend on something that is necessary or that will make you happy, by all means, redeem while you are in the positive and spend that money. Otherwise, since by your own admission, you have no use for that money in the foreseeable future, leave it alone.”
But I don’t think she was particularly convinced by what I was advocating because:
- I was denying her that thrill and even more importantly the bragging rights which go with it, of having made a generous profit from her investments NOW.
- Waiting for some number of years to feel that thrill – even if the profits would be much larger then – was what I call a “Now-And-Then” trade-off. A trade-off that is spread across time which all of us find much more difficult to evaluate rationally. Time dilutes perception of the pleasure of achievement since it is going to happen in some distant future. Redeeming it now and “Booking profits” now even if they are smaller in value has much greater perceived utility since the gratification is immediate.
- There were two phrases which were driving her motivation and behaviour without realizing that neither would make any material difference to her life or financial wellbeing. One – “Booking profits” and the second which the newspaper headlines had been screaming about – “Investors becoming poorer by lakhs of crores of rupees due to the market fall of 5%. Who wants to be poor and not make profits?
This phrase called “Booking Profits”, I have heard many times before and have always had problems understanding what exactly that means.
If I sell at a price greater than the cost at which I buy, I make a profit. That I understand. If I was running a grocery store, I would buy rice from the farmers at Rs.20/ kg and sell it to my customers at Rs. 30/kg and make a profit of Rs. 10/kg. And once my stock is sold, I would deposit that profit of Rs. 10 in a bank and go back to the farmer to purchase again at Rs.20/kg and come back to sell and that cycle will repeat. Of course, over time, the farmer may ask for Rs.22 instead of 20 and I too would then be forced to ask Rs.33 instead of Rs.30 from my customer. This process of making profits I understand.
But the analogous process of “booking profits” in case of investments, seems rather strange.
What my friend was planning to do in effect is:
Buy the rice at Rs.20/kg, sell it at Rs.30/kg (i.e., “book” a profit of Rs.10). Then spend those Rs.30 to buy rice again but at Rs.30/kg (because it is no longer available for Rs. 20/kg) and hope that over some period of time the price will go up to Rs.33/kg. Then sell it at Rs.33/kg and again wait, wishing the price goes up after some time to Rs.36/kg!
But instead of doing these complicated sets of manoeuvres, she would make exactly the same amount of profit, by just not doing anything till the price goes up to Rs.36!
This process of “booking profits” works ONLY IF, time after time I am able to find “rice” that can be bought at Rs.20 and sold at Rs.30 – again and again. That may be true if I was running a grocery store, but by and large it does not work if I am buying and selling mutual funds, because EVERY TIME I have “booked profits”, I have to be able to find some mutual fund that is grossly undervalued compared to what its fair retail price should be and therefore is available at a discount, for less than its true retail price. Only this will allow me to book higher profits again and again!
The methods that work for a grocery store owner to create a differential between his buying and selling prices to make profits – such as buy from the producer and sell to the consumer or buy in bulk and sell in retail quantities, buy unprocessed at sources then perform some value added process and therefore command a higher sale price because of the added value etc. – are not available to you to create a price differential that will continually generate profits, when you are buying from and selling mutual fund units to the same entity!
However, as I mentioned above, I don’t think my friend was in a mood to listen to all this, because all this sounds so dull and colourless when compared to the rush of adrenaline of making PROFITS NOW!