Market timing: a scientific approach

Mumbai: There is a common saying in the market that ‘you make profits when you sell, not when you buy’.

This simple statement underlines some of the key behavioral aspects of investing. If one were to understand, appreciate and follow this statement, making money at the stock markets would become easier and surer.

Most investorsa) Do a research on what stocks to buy and at what price, but fail to take the last step, that is at what price to sell; andb) Become anxious when it comes to selling their stocks.

Suppose you bought a share at Rs 100. One month down the line you find that the share has jumped to Rs 125. Twenty five percent returns in one month. Isn’t that great? Will you sell and book your profits? More often than not, you won’t – the reason: greed. You would hold on to it in anticipation that it will go up further and you will make more money.

Take the other scenario. Now the price, one month down the line has fallen to Rs 75. Too bad. Now, will you sell and book your losses? More often than not, you won’t – the reason: loss aversion. You would hold on to it in the hope that it will move back to Rs 100 at least and you will recover your losses.

In both scenarios, played time and again, you let your emotions rule your investment decisions. The end result is that you either lose money or do not realize the full potential of your investments. That’s why, financial experts, repeatedly advice that investors should have a selling strategy is place, before they even consider buying. Rationally, scientific selling strategy will keep emotions out and help you make more money, with less anxiety.

Decide on your stop loss percentageTaking into account the volatility of a stock and your loss-bearing appetite, decide on a stop loss level of 5-10 per cent. Preferably don’t go below 10 per cent. The moment your stock touches the stop loss level, get out. Don’t hope for the stock recover. Even if it recovers after you have booked a loss, don’t regret.

One way to overcome loss aversion is to look at the overall portfolio, rather than trying to make profit on every transaction. Concentrate on the overall returns and not the returns from each and every scrip. It is more often seen that this failure to accept loss at the right time, makes most people lose money on the stock exchange.

On the face of it, this may seem to be a defensive strategy, but more often than not it is this defensive strategy, which maximizes the overall returns. Moreover, with minor losses you still have a chance to play the market another day.

With huge losses to recover, one might be tempted to take aggressive risk, further jeopardising one’s capital. Too huge a loss can also permanently put you out of the markets.

Decide on your stop gain percentageAs mentioned in the beginning, you make profit when you sell. Therefore, when you decide to buy a stock, also fix a level at which you would sell.

Suppose your research shows that the stock, which you plan to buy, has a potential to up by 25 per cent in next six months. So your strategy could be to sell 1/3^rd of the stock, when it appreciates by 15 per cent, 1/3^rd by 20 per cent and the balance around 25 per cent.

Further, at each stage, you must re-research your stock to check whether you earlier assessment of 25 per cent expected upside still holds true or not. If the momentum is too strong and the fundamentals do support higher appreciation, you could modify your strategy to sell 1/4^th at 15 per cent appreciation, 1/4^th at 20 per cent appreciation, 1/4^th at 25 per cent appreciation and the balance at another 5-10 per cent appreciation.

Don’t ignore the time aspectYour research shows that the stock has potential of a 25 per cent appreciation in six months. But suppose nothing much happens for two-three months. This means you are losing opportunities to make money in other stocks. You capital is lying idle.

In such cases one must consider to move out partly or completely from the stock, if it remains inactive for fairly long time. One could of course come back to the stock when the momentum returns.

Timely selling, no compromise on capital protection and looking at the overall picture are the mantras, which will bring success on the stock markets.

The author, Sanjay Matai, is an investment advisor.