When is the right time to realize book profits?
Many investors are uncertain about when they should realize book profits. Frequently they act too soon or too late. It is therefore best for investors to take a tactical approach.
Investors often ask this question, probably because they are always needing to look for a new answer.
Investors often realize book profits too soon and book losses too late. This common behavior pattern is psychologically driven. Taking profits is often inspired by the proverb “A bird in the hand is worth two in the bush.”
Holding onto book losses, on the other hand, often reflects the illusion that a book loss is less real than a loss on a liquidated investment. The fundamental problem of such behavior patterns is that they – to revert to the card playing analogy – play the aces too soon, and sit on the losers too long.
A Tactical Approach to Taking Book Profits
Of course investors shouldn’t be “married” to their investments. But the point is that every investment decision should be made with a view to the future, not the past. If we start basing our investment decisions on the initial price paid, we move onto tactical thin ice.
And here’s another tactical fundamental on book profits: as a rule, it's worthwhile to “let the winners run” longer in shares than in bonds or currencies. First, because with shares, unlike bonds, the upside potential is unlimited. Second, as the investment horizon lengthens, shares profit from the risk premiums that they generate.
Why a Lack of Risk Premiums Is a Reason to Realize Book Profits
Currencies, on the other hand, offer no risk premium – no matter how long they are held. While it’s true that currencies pay different nominal rates, this rate spread disappears after taking into account the costs for currency hedging.
Bonds, in contrast, generate a lower risk premium than shares since as a rule they are repaid at book value. For this reason, realizing book profits on bonds – even in prospective terms – is a more obvious choice than when dealing with shares.
Even in the case of convertible bonds, the sky is not the limit. With this in mind, satisfactory book profits were recently realized on convertible bonds and GBP, whereas shares, with a proportion of 45%, are still given the highest weighting of all asset classes in a balanced mandate.