"Index falls by 200 points on profit booking". Investor's would have come across such headlines in business newspapers quite frequently, and wondered why markets react immediately to profit booking. At the very outset it would be appropriate to understand the meaning of the term "profit booking". Any investment is made with a definitive purpose, and generation of profit is one of the prime motivators for any investment, other than charity. Profit booking refers to the act of realising a profit on any investment through the process of buying/ selling. For a day trader profit booking is done on a day to day basis, whereas for a long term investor it occurs quite infrequently, depending upon the need for urgent funds or on achievement of the target price of a particular security. Profit booking is an art and every investor must learn this art to maximise his returns from the market.
Imagine, an investor telling you that he had invested in 100 shares of company 'A' 20 years ago by spending Rs.1000, and proudly claiming that his investment is worth Rs.5000 today. Assuming an annual inflation rate of 8%, the adjusted value of his investment would be Rs.4660, thus, in real terms his gain has only been Rs. 340 over a period of 20 years. It is definitely not worth taking the risk of equity investment for such a paltry gain. Had this investor booked profit on his investment, and re-entered at a later date he would definitely had made more money. Even the blue chip stocks also give ample opportunity to make substantial gains through profit booking. Of course no one can time the markets, so you cannot always sell at the peak and buy at the bottom. But some amount of profit booking is essential to optimise your gains on the stock market. If you do not know the art of profit booking you need not enter the stock market on your own, do invest through Mutual Funds, because your Fund manager shall improve your returns through profit booking.
Next is the important question when to book profits? Markets follow the time tested principle of valuation, where every stock is valued according to its worth. Though, in the medium term this principle is violated due to excessive speculation in the market. One must book profits when a stock is overvalued due to euphoria and re-enter when it gets undervalued due to poor sentiment. The most important indicator of valuation of a stock is Price to earnings (PE) ratio. Generally a lower PE indicates a time to enter the stock and vice-versa. But all low PE stocks are not the candidates for buying and not all high PE stocks are candidates for selling. Another indicator is the PEG ratio which is nothing but PE/ Growth. If the growth prospects of a stock are high it will have a low PEG ratio, even though PE may be high. This makes an attractive investment opportunity in that stock. An investor should not be wedded to a stock permanently, thus denying himself an opportunity to sell the stock during euphoria. For any dud stock in your portfolio, it is advisable to book a loss as well, and move to a decent growth stock. Booking a loss on your investment is a much more difficult task, because nobody wants a cut in the principal investment amount. But this painful decision making has to be learnt to cut down on prospective losses.
The current status of the equity markets calls for a partial 'profit booking', as our markets are trading at a 2010-11 PE multiple of 17-19 times, which seems overstretched at this juncture. The average returns from the stock markets from the lows of March 2009 have been over 100%, so there is a good amount of profit to be booked. The chances of Indian economy growing at over 8-8.5% are bright, but it will take some time before the stock markets are able to reach their previous highs. The news flow from global markets does not instill enough confidence in the current rally. There is a high probability of the Indian markets correcting anywhere between 10-20% from the current levels, which will offer a great opportunity to re-enter the markets to ride the next bull run.
