Be Smart And Scale Out When The Market Is Up
Knowing How to Appropriate Your Market Gains
It's no brainer to say that every investor is delighted when investments prove profitable. When your company pays out a hefty dividend in cash or bonus issues, you experience a lot of excitement. Similarly, a bull run in the market which sees your investments rapidly appreciating in value, or an isolated rise in a particular stock you hold, will send you wild with excitement. If, for instance, you bought First Bank of Nigeria PLC shares on 15th March 2005 when the market price was N23 and held it to date (end of July 2006) when it has shot up to N63 you will definitely know what excitement means. Or, if you picked WAPCO shares at N10.35 by same 15th March 2005 and saw the price rise to N40 by July end, 2006. Those are fairy-tale performances which every investor hopes to experience at some points.
The Tricky Point About Unrealised Gain
There's an important point to draw your attention to, however. The massive appreciation in the market prices of the cited stocks, to the investor, represents enhancement of the value of his investment and signifies a huge earned profit. There is a snag, however. The profit has only been earned "on paper" and is not in his pocket. It may never be. Accountants use the term "unrealised" to express the existence of such profit which needs to be converted to "realised" profit by taking action, in this case, to sell. That's only when you appropriate your profit and it becomes permanent.
The Big Dilemma
It would have been so easy to sell off your stock and realise your profit, if it was possible to accurately predict the market and price movements. In that situation, it would have been possible for the investor to determine when the price has peaked, so he offloads at the best possible price. However, since other investors will know that this is the peak price, he'll possibly not find a buyer. In reality, people will judge the market differently, which is why some will be buying in expectation of further rises, when others are exiting. The more critical point, however, is that the investor who wants to realise his profit is usually faced with a heavy burden of judgment: is it yet the best price to sell? While the price has risen and you've made a good gain, there is always the chance that the upward ride will continue. If you sell now and the price drives higher up by another 20%, that's a huge "loss" for you and will cause you some pain. Just as when you don't sell now and the price reverses quickly, going down by, say, 10% before you can sell. These scenarios will leave the investor in a catch-22 situation: sell now and possibly miss some of the profit or not sell and face the risk of price reversal.
Life Example
Guinness Nigeria PLC had its best upward run of recent memory in 2003. I already 5,000 units bought at an average cost of N26.93 . The market expected good returns at its year-end and the price zoomed to N60, then N70. At this point, I felt it was a huge gain already. When the price vacillated at N70 (swinging around this level for a while), I thought it had peaked and sold off my holding. But the price powered on, hitting N80, N90 and more. Eventually, the results announced by the company were excellent, with bumper returns in cash dividend and bonus issue. Guinness continued on ride to ultimately peak at N1, leaving me with a "loss" of over N . Yes, I made a gain on the stock, but forfeited a huge potential gain due to a panicky, hasty and premature sale. I didn't have composure to re-enter quickly. That left me reeling in anguish and complaining loudly to my colleagues at work.
A Smart Way To Beat The Odds
Now, you don't have to give up so much potential gain due to precipitate action, or run the alternative risk
of suffering a decline because you expected further rises and saw a sudden price crash instead. You can deploy a formula that easily balances your risks and leaves you better protected. That formula is called 'scaling out' or 'taking partial profits'. Simply put, it requires you to gradually lock in the profits during the upward ride: you partially realise your profits at certain milestone levels.
Illustrating The 'Scaling Out' Approach
Let's illustrate this with my Guinness transaction. When I felt the price was peaking at N70, I could have sold, say, 2,000 units. If the price suddenly reversed and went down, I would have regretted not selling all at N70, but would have been relieved that I captured some of the gain at that level. It's a better result and would leave a healthier feeling than if I didn't sell at all. The rest could be sold at the reduced price. However, contrary to my expectation, the price could gather steam and zoom forward, as was indeed the case. I could wait again to, say, N90 and sell another tranche of, say, 2,000 units. More gain for me and less regrets than was the case when I sold all at N70. Anyway, the price galloped forward, well beyond N100. Chances would have been that with only 1,000 units left, I would have been willing to take more risk and wait out the price run, perhaps selling at N130. Or possibly not sell anymore, since, by this time, the N7.92 dividend and 2:3 bonus proposed by the Board was already known. This phased profit-taking approach would have given me a chance to benefit from the continued bull run of the stock while protecting me from the full potential loss that was possible if the price crashed at any of the decision points. Let's check out the numbers for the three options mentioned here:
| Actual Action: Sold all at |
Alternative 1: Phased sell of all |
Alternative 2: Phased sell, retaining 1,000 |
|---|---|---|
| 5,000 x = |
(1) 2,000 x = (2) 2,000 x = (3) 1,000 x = |
(1) 2,000 x = (2) 2,000 x = (3a) Dividend on 1,000 = (3b) Value of retained 1,000 + 666 bonus at marked down price = N131,614 |
| TOTAL = |
TOTAL = |
TOTAL = |
The additional earnings impact of the alternative options is very obvious. Even if the price had reversed at N70 and I sold the balance of 3,000 at, say, N65, total realised would have been N335,000, N15,000 below total sellout at N70 option. Risking this amount of loss for the potential to earn the additional profits of the alternative options would seem justified.
Optimise Realised Profit With This Formula
If you simply watch prices go up and slide back without taking action to capture the gains, you will only make paper profit and possibly could end up without any enhancement in value. If, instead, you panic and offload your stock during an upward run but long before the price gets to peak, you will be forfeiting a lot of earnings that are legitimately yours. Deciding at what price to sell is a tricky game, given that price movements are not accurately predictable. So, take a balanced approach that optimises you earnings. Scaling out, also called taking partial profits, can reduce your headaches and leave more money in your pocket.
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