When “Pocketing Your Profit” Kills Your Profit

“Fifty percent return in just six months! Maybe it’s time to sell…?” Kenny wondered, a mixture of exhilaration and unease dancing in his eyes.

Kenny and I were relaxing on the patio of a coffee shop as his kids played in the park nearby. Kenny was the type of person to second-guess himself and overthink, so before making a big decision, he always felt the need to ask around for advice.

“Well, I wouldn’t know,” I told him, “Tell me about the company.”

As he gently swirled the foam on his cappuccino, he delved deeper into the story of his investing journey. An electric excitement laced his words as he recounted the meteoric rise of a company he’d bet on. The company was a trailblazer, marked by groundbreaking innovation, formidable growth numbers, and a talented leadership team steering it into the future. But despite his belief in its prospects, the growing clamor to ‘secure the profits’ was beginning to chip away at his resolve to stay invested. 

“Everyone around me seems to think it’s time to cash out,” Kenny continued, stirring his coffee with a thoughtful gaze. His wife, pragmatic and cautious, believed that ‘a bird in hand was better than two in the bush.’ His banker, a seasoned professional with decades of experience, also weighed in, endorsing the wisdom of taking profit while it’s there. “After all, who knows what tomorrow brings?” “the banker said, with an air of knowing sagacity. Some of his friends, a varied group of enthusiasts who dabbled in investments, shared their personal stories, painting a vivid picture of past regrets. “Greed was my downfall,” said one, recounting how he’d held onto a soaring stock for too long, only to see it crash before he could sell. “I’d have been so much better off just taking the profit when it was there.” 

With all these voices echoing the same advice, it seemed like a foregone conclusion. ‘Take the profit, secure your gains’ was the overwhelming consensus.  

“Well, then, what do you think, Kenny? How sure are you about the company’s future?” I asked him. 

His eyes sparkled with a confidence only derived from years of expertise. “Very sure! You know, I’ve been in this industry for decades,” he started, “and I can tell you, the technology they have is unlike anything I’ve seen before. Their pipeline is extraordinary and they are pioneers in their field.” Leaning back, he spread his hands. “The team is made up of the brightest minds in our field. They’re all best-in-class. There’s a reason why I’ve put so much money here.” 

In response to his resolute conviction, I reply, “then ‘pocketing your profit’ might be a stupid idea.” 

Though a contrarian I have always been, the idea I just proposed to Kenny isn’t just a whim of mine. Let us take a look what Peter Lynch said in an interview with Forbes Magzine(source):

Lynch told Forbes that Buffett taught him to embrace what he calls his own “greatest mistake,” which was that he “always sold stocks way too early”. 

“It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds,” Lynch said. He added that he mistakenly sold his stocks in Home Depot and Dunkin’ Donuts too early because they would have soon grown over fiftyfold. 

“Why did I do that? I was dumb,” he told Forbes. 

“If you’re great in this business you’re right six times out of ten. But the times you’re right,” Lynch said, “it overcomes your mistakes. So you have to find the big winners.”

To those who don’t know Peter Lynch, this is how he was introduced by CNBC:  

Nicknamed “America’s money manager” by Forbes, Lynch became well-known for managing the Fidelity Magellan Fund and growing its assets from less than $100 million to $13 billion. As a result, he established the world’s best-selling stock fund for over a decade during the 1980s bull market.

Warren Buffett also admitted  to selling stocks too early. In his annual shareholder letter, he said, “Late in 1993, I sold 10 million shares of Cap Cities at $63; at year-end 1994, the price was $85. (The difference is $222.5 million for those of you who wish to avoid the pain of calculating the damage yourself.) When we purchased the stock at $17.25 in 1986, I told you that I had previously sold our Cap Cities holdings at $4.30 per share during 1978-80, and added that I was at a loss to explain my earlier behavior. Now I’ve become a repeat offender. Maybe it’s time to get a guardian appointed.”

The fundamental reason is that great investment opportunities are indeed rare, just like extraordinary blooms in a garden. It makes selling a strong investment a regretful decision. 

According to a 2017 study by Hendrik Bessembinder of Arizona State University’s W. P. Carey School of Business, “A relative handful of stocks are extraordinary performers. Only 4 percent of all publicly traded stocks account for all of the net wealth earned by investors in the stock market since 1926. A mere 30 stocks account for 30 percent of the net wealth generated by stocks in that long period, and 50 stocks account for 40 percent of the net wealth.” Essentially, these 4% are the flowering plants in our investment garden that yield bountiful fruits, while the vast majority are mere weeds.

One reason that so many people have the impulse to “pocket the profit” is that they are treating investment as if they’re at a casino, and stocks are nothing more than fancy slot machines. The moment their slot machine “Ka-chings” with an unexpected ‘jackpot’, their eyes light up with dollar signs, and their first instinct is to rush to the cashier’s desk before their luck runs out. 

But here’s the kicker – investment isn’t about playing slots in the neon-bathed halls of Las Vegas. It’s about owning a goose that lays golden eggs. Now, if you’ve stumbled upon such a goose, would you rush to slaughter it for a celebratory soup just because it has started laying those gleaming eggs? Of course not! You’d nurture it, feed it, and wait for it to lay more and more of those valuable eggs. 

Another possible reason why people often succumb to the urge to sell when stocks are rising is rooted in psychology. Research conducted by Nobel laureate Daniel Kahneman and his colleague Amos Tversky revealed that individuals tend to feel the pain of losses twice as intensely as the pleasure of equivalent gains. This psychological bias can greatly impact investment decisions, causing investors to sell prematurely out of fear of losing their paper profits. The psychologic bias named “Loss Aversion” is deeply ingrained in our psyche, and it can play tricks on our rational thinking. We become fixated on preserving what we have gained, even if it means missing out on potentially greater future gains. It’s as if our brains are wired to prioritize the avoidance of losses over the pursuit of further gains. 

As we can see, too many “pocket your profit” ideas are siren songs that lead us astray from the path of long-term wealth creation. To resist this temptation, we must remember that great investments, like a goose that bears golden eggs, are rare finds. If Kenny truly believes he has found such an investment, it would be wise for him to give it more time to grow. Conviction in an investment is not born out of blind hope or luck; it is cultivated through continuous learning and understanding. Kenny’s confidence in the company’s potential stems from his deep understanding of its business, the industry it operates in, and the future prospects it holds.  

Learn to earn, act to prosper.