One of the worst Investing anecdotes which often gets told is “You will never go broke taking a profit”. This essentially means that it is always possible to sell a good stock and buy a better one. Do you really think so? Let’s take a small example:
Scenario 1: Let’s assume you start with investing INR 100 in Company A and make 15% return in Year 1. You don’t follow the above anecdote and don’t take the bait of selling it in Year 1 itself. Fundamentals of Co A improve in Year 2, followed with a 20% return. Thereby, you make 38% total return for the entire 2-Year period. Your net-worth becomes INR 138 at the end of Year 2.
- Invested: INR 100
- Year 1: Market Value = 100 X 1.15% = INR 115 (15% return)
- Year 2: Market Value = 115 X 1.20% = INR 138 (20% return)
- Total 2-Year Return = 38%
- Net-worth at the end of Year 2 = INR 138
Scenario 2: Let’s assume you make 15% return in company A in Year 1. You follow the above anecdote, after all you are making money while the markets have been plunging. You sell Co A to invest in Co B. This act of taking profit results in capital gains tax of 20% in short-term. To achieve your net-worth goal of INR 138 in Year 2, Co B’s return should by 23% in Year 2.
- Investment in Co A: INR 100
- Year 1: Market Value of Co A = 100 X 1.15% = INR 115 (15% return)
- Sale of Co A would result in 20% capital gains tax, i.e., 20% of (115 – 100) = 3
- Investment in Company B = (115 – 3) = 112
- In order that your net-worth at the end of Year 2 is INR 138 (Scenario 1), Stock B’s return should be 23%, i.e., (138 / 112) – 1 = 123% – 100% = 23%
Brokerage charges & Securities Transaction Tax have not been considered in the above calculation.