Profit Taking Psychology | February 21, 2023
This write-up’s purpose is to help investors understand common mistakes and psychological pitfalls that keep people from realizing profits on investments, and provide some actionable suggestions for improving in this area of investing.
Psychological Barriers to Selling
One of the most common struggles of both traders and investors is knowing when to take profits, especially in crypto. There are many psychological barriers at work that lead to most investors ‘round-tripping’ their profits back to zero, or even into deep losses.
Overcoming these psychological barriers to profit taking is essential to maximizing returns and avoiding large losses.
Here are some of the psychological traps that commonly lead to losses.
- Repeated Pattern of Returns
When an investment is performing well in a bull market, many will actually feel the desire to buy more of the asset or other risk assets at elevated prices rather than sell.
You buy, you make money, you want to repeat this process, so you buy again. And again. And again.
But you never sell the original investment because the numbers keep going up.
Because the numbers keep going up, your conviction grows. You continue to buy more and more.
The by-product of this is that your average entry price is now considerably higher than your original entry price.
And now it only takes a 30% pullback for you to be back to break even. Any more than that and you’re underwater. Because you kept buying, you’re strapped for capital. Price dips below your break-even and you find a way to buy the dip, but now you’re out of money.
Price keeps going down and now you’re severely underwater on an investment that was originally quite profitable.
This is exactly how many retail investors ended up losing money in a massive bull market that should have been easy to make money in.
- Unrealistic expectation to time the top.
There is an uncanny desire, and even expectation, to time the top, and sell 100% of an investment at the exact peak. Not only is it statistically unlikely, there are many unpredictable variables that can dictate when the top actually occurs.
Let’s take Solana for example. Out of the last 933 trading days of Solana, there are only about 14 days worth of price action spent within 10% of the top.
Yet the idea of selling an investment below 10% of what it once was worth is difficult for many to digest in the moment. Trying to time the top with 100% of an investment is a risky endeavor, and one that will often leave you bag holding to new lows, or missing out on additional gains.
Most investors have no issues accepting the fact they they will never time the bottom 100% perfectly. Thus a dollar-cost-averaging strategy is commonly adopted for entering an investment.
The same investors, however, commonly think timing the top when exiting an investment is different, when in reality DCA’ing out of an investment is equally appropriate regardless of entering or exiting.
Furthermore, parabolic moves can end based on completely unpredictable variables:
- A whale decides to start dumping.
- Regulatory legislation is passed that hurts the asset’s future.
- Legal scandal surrounding founders or team members.
- The Fed pivots their monetary policy.
A common issue here is that by the time you hear about whatever negative news has caused price to top out, there may already be a 15-20% pullback. Weighing this against your confirmation bias of expecting the asset to continue to perform well means you are more likely write it off as temporary, and wait for a bounce-back before selling. You also don’t want to panic sell at 15%+ below all time highs, just for it rip right back up.
- FOMO. Buy back Higher.
A common reason for not selling at elevated levels is the fear of missing out on further upside. As mentioned already, timing the top perfectly is incredibly difficult to do, and quite unlikely.
Therefore, there will almost certainly be additional upside that you miss out on by selling.
Accept this fact, and take profits anyways. If you bought ETH at an average price of $200 and sold at $2k, you made a 10x return. That is a massive win. You made a successful investment. Celebrate it as a win and don’t look back. Look for the next opportunity. Do not dwell on the fact that it continued to run to $4.8k and you could have made a 24x if you timed your sale better. Always look forward, not back.
- Convincing yourself that an irrational, life-changing price target is likely.
People who bought Solana >$200 were likely convinced it was going to $1000+.
Here’s the thing… It possibly could have. This is why timing tops is so difficult.
If the Fed had kept printing money. If Solana didn’t have network outages. If Bitcoin mining had not been banned in China. If large VC funds decided to wait longer to take profits. If all these things were different, Solana very well could have had a run to $1000.
But just because it’s possible doesn’t mean it’s likely.
This goes hand-in-hand with #5.
- Total lack of market awareness.
Irrational price targets are often a by-product of a complete lack of market awareness. Many times, the “irrational life-changing price target” has already been achieved.
Let’s say you invested $10,000 into AVAX at $5.
AVAX ran from $3 to $147.
Would you be inclined to take profits at $20? Maybe. Would you be inclined to take profits at $140, when your $10,000 is now worth $280,000? Let’s hope so. You may not have invested at $5, but someone else in the market did.
As price goes up, the incentive to take profits increases. And taking profits (selling) is what pushes price back down. When and asset gets extremely over-bought, the incentive for people to sell and take profits is high, meaning the risk of a large pull-back or crash is also high.
Many investors look at a chart and don’t fully understand just how over-bought or over-sold a cryptocurrency is. Luckily, there are some simple ways to quantify this, one of which are the EZ Bands indicator that is included in your Research Hub subscription.
The EZ Bands are a great way to visualize how over-bought or over-sold a cryptocurrency is. Note that they are not designed to be a binary buy/sell signal, and many assets can remain over-bought or over-sold for extended periods of time in secular bull/bear markets.
Solana ran from $1 to $260. Buying at elevated levels expecting another 4x to $1k is reckless behavior. The down-side risk, and likelihood, far outweighs the upside potential.
- Listening to others, particularly influencers.
People often listen to bombastic headlines and influencers instead of making their own decisions. There is nothing wrong with intaking quality information and analysis from a variety of sources.
In fact, that’s smart. But unfortunately, high quality sources of information and analysis can be difficult to find, and bad information is often forced upon you by social media algorithms.
Many see a high follower count and assume that it is ‘social proof’ that a person’s views and opinions are to be regarded as refined.
In reality, it’s often the opposite. Most topics, crypto being no exception, are complicated and nuanced. The masses are either incapable of understanding, or unwilling to engage with, nuanced and complicated analysis. We see it in politics. We see it in tech. We see it in finance. We see it in crypto.
Surface level analysis (easy for the masses to understand) that concludes extreme outcomes is what algorithms reward. The Bitcoin Stock-to-Flow model and Bitcoin Rainbow chart went viral because of this. Both have been completely invalidated in the bear market.
If you aren’t careful, influencers and media headlines may push you to make poor decisions when it comes to taking profits.
Find a few quality sources of information and use them to craft your own analysis and decisions.
Now that we’ve discussed psychological barriers to taking profits, let’s talk about profit-taking strategies.
There are quite a few factors to consider when exiting an investment. Let’s discuss the different reasons to sell.
1. Trading your PnL
This is a common strategy, particularly among novice investors (which is not necessarily a bad thing). Trading your PnL simply means taking profits in accordance with the performance of the investment regardless of other factors such as market performance and/or technical analysis.
For example, if you bought ETH at $800, you might be inclined to sell at PnL milestones such as 2x, 3x, 4x, and 5x which means you’d be averaging out at $1600, $2400, $3200, and $4,000.
Another example of ‘trading your PnL’ is making an investment of $10,000 and taking some profits when it hits certain milestones such as $20k, $30k, $40k - regardless of the asset’s underlying price.
The benefit here is that it largely removes emotion from the decision to take profits as you plan to sell at these milestones regardless of market conditions, technical analysis, or sentiment.
The drawback is that introducing some basic analysis could yield higher returns. But again, most mistakes (and losses) in investing are emotionally driven, so the idea of removing emotion is quite compelling.
- Trading Real Life Milestones
Trading real life milestones simply means taking profits when it makes a large impact on your personal finances and quality of life.
For example, say you invested $100k into crypto and now your investments are worth $600k. After taxes, selling everything might yield you $420k. Let’s say you have a $350k mortgage and still owe $15k on your car.
Selling everything at this point gives you the ability to pay off your home and car, and live with significantly lower expenses. You could go on more vacations, take some time off work, increase your monthly savings, spend more time/money on hobbies you enjoy, have very little financial stress, etc.
Hitting that $600k in portfolio value is a huge real life milestone in terms of the immediate quality of life improvement it gives you. If it dropped even 33% (which is quite common and likely in crypto) to $400k, all of a sudden the ability to pay off your house and car is gone. The unrealized loss is $200k AND no financial freedom.
By selling everything at $600k, your total profits after tax are $320k PLUS financial freedom. Given your unique circumstance, the actual impact of the money on your life is greater than it would be for someone who has $20M and can easily take a $200k loss without it impacting their ability to change their lifestyle.
In other words, if your investments reach a threshold that changes the literal architecture of your life for the better, you have increased incentive to take profits.
To really drive this example home, imagine your portfolio continued to run up to $1.1M. The first $500k in profit has a more direct impact on your life than the 2nd $500k in profits, meaning that for YOU the first $500k is worth more than the second $500k, even though they are technically the same $ amount.
The benefit of this is that, again, you remove emotion from the equation, and simply sell when profits reach a life-changing milestone.
The drawback is that sometimes your real-life milestone may be too far away and your investments do not reach that high before crashing, and you miss the opportunity to take profits. Another drawback is the lack of analysis that goes into the decision to sell, which may lead to lower profits.
Lastly, a third drawback is related to individuals life-planning and longer-term financial strategy. Technically speaking, paying off your house in full may not be the most ‘capital efficient’ way to spend that money. When you pay off your house, you are essentially locking in a return equivalent to the interest rate of your mortgage. So if your mortgage is 3% and you pay off your $350k mortgage, you are essentially guaranteeing a 3% rate of return on that money for the duration of the mortgage. Alternatively, you could deploy that $350k elsewhere and seek a higher return. For example, let’s say you can achieve 4.5% in the bond market. You’re netting an additional 1.5% on your capital compared to paying off your mortgage, with pretty minimal risk. Also, by paying off your house, you forgo other, higher risk, investment opportunities that could compound in a big way. The saying “you need money to make money” is quite true. If your goal is to get to a net worth of $10M, $350k compounds a lot faster than going back to zero, despite having zero debt. Ultimately, trading real life milestones is highly personal.
A final note/warning: Capital efficiency comes with risk. Many funds have blown up trying to maximize capital efficiency.
- Trading the Chart
Trading the chart in this context simply means taking profits according to technical analysis. If the price of an asset is at significant resistance levels and/or is overbought, it makes sense to take profits as the asset is more vulnerable to decreasing in price.
The drawback here is that most people are bad at technical analysis. It can also be a gateway drug into ‘over-trading’ where investors try to bounce in and out of investments on a short-term timeframe and end up getting chopped up. It’s also difficult to avoid introducing confirmation bias to technical analysis.
For example, an asset may have 3 indicators that appear bullish and 5 that appear bearish. If you want the asset to go up in price, you are more likely to focus on just the bullish indicators and ignore the bigger picture.
The obvious benefit to this profit taking strategy is that when executed properly, you can avoid large losses and maximize profits.
A few examples of profit-taking signals from a technical analysis perspective are:
- Bearish divergence on RSI:
- Resistance zones:
- Trading the Market (and Cycles)
Many times an individual asset’s performance can be largely dependent upon a larger set of variables such as macro-economic conditions, geo-political events, regulatory pressures, legislation, etc.
A perfect example is trading the Bitcoin halving cycle. It’s logical to purchase crypto in a bear market well before a Bitcoin halving, and sell 6-12 months after the Bitcoin halving after a period of speculation has ensued. Likewise, we have recently seen the benefits of selling before the Federal Reserve entered a quantitative tightening regime.
Some assets may be outliers that perform differently than the rest of its native asset class, but generally speaking, trading broader market conditions can help to avoid large draw downs.
There are other reasons to sell/take profits that are not necessarily planned.
- If the fundamentals of an investment change for the worse, it may make sense to sell. For example, a founder makes a series of poor decisions or unfavorable regulation is passed that directly pertains to the asset.
- Forced selling is when an investor must sell an asset against their will to pay off debts due to being over-leveraged or over-exposed. Don’t be this person.
- Panic selling is when an event (usually external) causes price to crash in the short-term and investors sell out of fear. Whether or not panic selling is the right decision is situationally dependent. It is usually best to defer to whether or not the asset’s fundamentals have been compromised.
Beware of HODL culture.
HODL culture is the culture of not taking profits. There is nothing wrong with having a long-term time horizon for an investment, and sticking to that time horizon.
However, it is unwise to ignore circumstances that incentivize taking profits. Allaying some risk by taking profits on occasion is far more ideal.
Note that in the crypto space, there is a very large percentage of projects that simply do not succeed long-term. Additionally, the crypto market is extraordinarily prone to large crashes. 50%+ pullbacks are commonplace. Sitting through a predictable 50-90% drawdown is not productive.
Many investors make the mistake of entering an investment without setting clear criteria for exiting. Setting criteria for taking profits will help you feel more confident when it becomes appropriate to exit.
- What is the timeframe for this investment? 3 months? 3 years?
- What kind of price target is achievable? What is this based on? Expected market growth? Comparable assets?
- What fundamental changes would invalidate your investment thesis?
As cliche as it sounds, failure to plan is planning to fail. Failing to set exit criteria for an investment often leads to never selling it, and ‘round-tripping’ the investment back down.
Don’t marry your bags. Some of the most high-performing investments are supported by cult-like communities of investors (who often times pseudo-worship the leader).
Bitcoin is a cult.
Ethereum is a cult.
Apple is a cult.
Tesla is a cult.
Dogecoin is a cult.
Cardano is a cult.
Bored Ape Yacht Club is a cult.
DeGods is a cult.
They are all cults. Don’t get indoctrinated. When it’s time to sell, be willing to sell.
If you refuse to sell because you want to be a ‘part of the community’ in perpetuity, you must accept that you are no longer an investor. Instead, you are paying a membership fee.
There’s nothing inherently wrong with that, but don’t operate under the delusion that an investment that you never plan sell is still an investment.
There is no wrong way to take profits. Taking profits should be treated as an isolated, positive, winning event with no regrets. Once a position has been exited, it is unproductive to dwell on what could have been. Learn from it, and find the next opportunity. In hindsight, it was the optimal move to put your entire net worth into Solana at $5 and sell it all at $260. But even in hindsight, it was not the right decision. Most times this type of degenerate gambling behavior leads to loss.