Making a profit on our investments is what investing is all about. That almost goes without saying. Investors generally buy shares in the hope that, sometime in the not-too-distant future, they will appreciate in value.
As sensible investors, we should already know to invest with money that we don’t need for the next five years. That way, should the shares that we bought fall, we would not be too distressed.
We might be a bit disappointed but probably not too anxious. After all, we are not desperate for the cash. Still, we do not set out to buy shares to watch them fall in value. We want them to go up in price.
Where’s the profit?
What happens when those shares start to appreciate in value? Have we made a profit yet? According to our portfolios, we almost certainly have. But those profits are simply an unrealised gain. They are known in the trade as a paper profit.
The profit is calculated from the difference between the current market price and original purchase price of the stocks. In theory, they are profits – but the profits are not crystallised until we sell the shares and bank the cash.
Once we have completed the sale, that paper profit becomes real money that we can go out and spend or perhaps use to buy even more shares. That sounds simple enough – buy shares when they appear cheap, then sell them when they go up and bank the profit. Selling at any price higher than our buy price plus any transaction fees incurred should guarantee a profit.
But where should we set that selling price? Is a 10 per cent profit good enough? Should it be higher? Should we aim to make at least 20 per cent or 30 per cent? It is not a straightforward decision to make. But why is it so hard to set a selling price?
When is a share overvalued?
If that sounds like you, then you are not alone. Many investors seem to have a slight problem in deciding on the right price to sell their shares. In other words, it is often not easy to know when a share is overvalued.
Those same investors have little difficulty in deciding when to buy shares, though. They appear to have a fairly good idea of when shares of a particular company are undervalued. But the same cannot be said when those same shares start to look a touch expensive.
It would seem that our ability to rationalise a company’s value becomes clouded by the worst of those human failings – greed. But here is the catch – when we sell a share, there is a willing buyer on the other side of the trade.
So, we might think that a share is overvalued and we, therefore, sell the counter. But there are buyers on the other side who believe that the share offers value for money, which is why they are prepared to buy them. Who is right?
Ironically, both are right. Investors and traders buy and sell shares for all sorts of reasons. Those reasons are not always aligned. Value investors, for instance, buy shares when they believe that the price is below the share’s intrinsic value. Once the value has been outed, value investors have no qualms about selling. Their objective has been met.
Growth versus value
Growth investors, however, might believe that there is still plenty of mileage left in the same share. So, while the value investor has no interest in the growth aspects of the business, the same cannot be said of the growth investor.
Income investors could straddle both camps. They might buy a dividend-paying share when it appears ostensibly cheap. They might even continue holding on to the shares, provided they continue to pay regular dividends.
What is interesting is that there are no hard-and-fast rules about investing. Consequently, it is sometimes easy to fall into the trap of taking profit too early. It is of course true that you cannot ever go broke taking a profit. But business magnate and investor Warren Buffett pointed out that we should not overly fixate on what we have paid for a stock. He added that we should not rush unthinkingly to grab a small profit, either.
He noted that regardless of price, he has no interest in selling a good business. He went as far as to say that he would not even sell a sub-par business provided it can at least generate some cash. What is important, he felt, is that we feel good about the business and the people who work there.
So, the question for us is whether we treat the shares in our portfolios as tickers and counters that we can buy and sell.
Or do we see them as businesses that are able to provide us with a stream of income long into the future?
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: David Kuo does not own shares in any of the companies mentioned.
