Suppose you bought two stocks- Stock A and Stock B. The buying price of both these stocks is the same, i.e. Rs 100.
After two years, you checked the returns from both these stocks and found that the current price of stock A has moved to Rs 180. On the other hand, the market price of company B has fallen to Rs 60. What would you do next?
Would you sell stock A and book a profit of 80%? Or Would you sell stock B to get rid of your losing stock?
I will give the answer to this question in a few minutes. But first, let’s discuss another scenario in a similar context.
Let’s say, you have a garden where you’ve planted three vegetables- Ladyfinger, tomatoes, and Cabbage.
Out of the three, Ladyfinger and tomatoes are doing exceptionally well. They are growing big and healthy. And that’s why you are able to make huge profits by selling them.
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Anyhow, the third vegetable i.e. cabbage is just not doing well. It is not growing enough, no matter how much time, money and efforts you spend on planting those vegetables. It simply dies out without producing anything worthwhile to sell.
What’s the logical step here for you as the gardener?
Shouldn’t you get rid of the Cabbage which is not growing no matter how much efforts you put and focus more on growing the other two vegetables which are giving you awesome returns? After all, those two vegetables are the ones who are making you profits.
A similar concept should be applied in the stock market world.
Out of the two stocks- Stock A (which went up by 80%) and stock B (which fell down by 40%), it’s logical to hold the winning stock and get rid of the losing one.
Why do you want to sell Stock A to book a profit of just 80%, when it can get returns of 100%, 200%, 500% or even 1,000% in the future? If the company is fundamentally strong, selling its stocks just to book short-term profits doesn’t make much sense.
On the other hand, keeping the losing stock just to break even is also not a wise strategy. If you get rid of that stock and invest the same money in stronger companies, it can give you better returns. Holding the losers just to break even may lead you to loss of both time and money.
Here, the biggest lesson that every beginner should know is- “Hold your winners and cut your losers!!”.
But sadly, most people follow the totally opposite approach while investing. Even if the stock moves up by 30%, most beginners are eager to sell that stock, book profit and boast among their friends.
The majority of the investing population would prefer to sell their winning stocks just for instant gratification of short-term profits. However, booking short-term profits should not be the goal of the investors if they want to build long-term wealth. After all, the consistent returns should always be preferred over a one-time profit.
The only reasons when you should sell your winning stocks is A) when the company’s fundamental changes and the stock is not as strong as when you originally invested, B) When you find a better stock to invest with bigger opportunity and C) when really need the money. For all the rest cases, you should stick with the stock.
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Besides, one more thing that most beginners ignore while booking short-term profits is taxes. When you sell your winning stock in short-term for booking profits, you are obliged to pay short-term capital gain (STCG) taxes of 15% on your profits. Therefore, this portion of the profit is already gone to the government.
Nonetheless, you can easily avoid/delay this STCG gain tax by NOT selling your winning stocks and keeping it for the long term. After all, you only have to pay taxes when you book profits. Moreover, Long-term capital gain taxes are comparatively smaller (i.e. 10% of your gains). Therefore, by investing for long-term, you can save a few additional bucks.
Overall, whether you are investing in stocks, mutual funds or any other investment option, the first and biggest lesson is the same- “Cut your losers and hold your winners!”.
That’s all for this post. Happy Investing!!
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting