Concept of Profit Booking and How It Affects Stock Markets
If you have regularly observed the stock market, you may have noticed that a lot of time when the market falls, experts attribute this fall to profit booking. The concept of profit booking is known to a lot of people. However, the knowledge is merely superficial. In this article, we will have a closer look at the concept of profit booking.
What is Profit Booking ?
Profit booking, also known as profit taking is when individuals or companies liquidate their holdings to cash out the profits that they have created. It must be understood that for a situation to be called profit booking, there has to be a profit involved. If stocks are liquidated and cashed out to avoid losses, then such a situation cannot be called profit booking. There are a couple of more features of profit booking that are described in this article.
- Notional Wealth vs. Real Wealth
- Temporary vs. Permanent
When stocks rise in value, the resultant wealth created is nominal wealth. This is because the price of stock is only a notion that can change at any point in time. Therefore the value is not stable and keeps on fluctuating. Any profits and losses calculations made using this value are merely notional.
On the other hand, when the investments are liquidates, investors have hard cash in their hands. The value of hard cash does not fluctuate. Therefore the wealth created is real. Therefore, in other words, the transfer of nominal wealth to real wealth can be called profit booking.
When profit booking is done, money flows out of the market. People liquidate their shares for cash. Therefore, there is an inflow of shares and an outflow of cash. This situation leads to the price of the stocks falling. As a result a slump is created in the market when a lot of people indulge in profit booking. However, the slumps created as a result of profit booking are extremely temporary in nature. These issues get resolved and the stock price comes back to normal in a matter of days since there is no problem with the fundamentals of the stock. Profit booking are just temporary aberrations created by market sentiments.
Situations in Which Profit Booking is Commonly Done ?
The following situation leads to investors cashing out their investments en masse.
- Company Specific News: There may be times when company specific positive news hits the market. Lets say this company has won a massive contract or has developed some new technology. In such case, at first a lot of people will start buying the stock. This excessive buying will lead to a price rise. As a result, the investment targets of a lot of people are met. This causes them to sell out their stock causing a temporary slump in the market induced by profit booking.
- Sector Specific News: Just like there can be positive news for a single company, there can also be positive news for a sector. Once again, first there will be a rise in price followed by a peak, then followed by a selloff leading to a temporary slump.
- Economic Data: Macro economic data can also cause people to book profits. In some cases, the future projections of macroeconomic data may not be that positive. As such organizations and individuals may want to cash out their investments given the bleak future opportunities.
Profit Booking Strategies
Investors have to adjust their portfolio after the profit booking takes place. There are multiple ways to accomplish this. Lets look at some of the most common ways.
- Restoring the Original Allocation: Restoring the original allocation decided by the investor is one of the ways of dealing with profit booking. Lets say an investor had a portfolio that was 60% equity and 40% debt. The growth in this portfolio caused the percentages to change. Since equity grew much faster than debt, the percentage changed to 75% and 25%. Therefore when equity is sold off, the investor can use the proceeds in such a way that the original 60%-40% balance is restored. This technique allows investors to automatically spend less on buying overvalued assets and more on assets that may deliver in the future.
- Above a Particular Percentage: Another strategy used by investors is target based investing. For every investment, the investor decides a specific percentage of growth per annum. If that growth target is exceeded, the investor will sell off the asset and buy an asset that may be depressed or undervalued. Hence, for instance if I purchase a share for $100 and have a target of 18% per annum, whenever the share breaches that mark, I am simply going to sell it and buy an asset that is undervalued at that time. A lot of time this target is not set by the individuals but by the brokerage firms that provide buy and sell recommendations. It has been commonly observed that when these recommendations are reached, markets usually experience a profit booking induced slump!
Profit booking is therefore a certain phenomenon. People will always want to liquidate their investments when their targets are met. As an investor, one needs to understand how to navigate these events. Sometimes it might be advisable to sell off ones holdings whereas at other times it may simply be advisable to hold on.
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