Realized vs Unrealized gains and losses
The stock market is freaking nuts! The Dow is up, now it’s down, now it’s the highest it’s ever been, now its dropped the largest percent in history…what the hell is going on? You’ve lost big, then you’ve won big, and now you’ve lost again. But have you really lost? Did you realize your losses? Knowing the difference between realized and unrealized gains and losses is incredibly important.
The Big Secret
The truth is that neither gains nor losses are real until you make them real! (Of course, there are exceptions to every rule. The one exception to this rule is if an individual stock you hold goes bankrupt…that loss is usually real!). But in most other cases, you don’t score big until you realize your gains, and you don’t lose big until you realize your losses.
Unfortunately, a lot of people don’t always understand this. Maybe they do on a logical level, but when emotions get involved, that logic can fly out the window. When stocks plummet, people tend to freak out and sell. So, what ends up happening? They realize their losses at the worst possible time, and lose a whole bunch of money. If they would have stayed invested, the markets would eventually improve and they would never have realized the loss. In effect, they wouldn’t actually have lost money!
Exceptions to every rule
There are caveats to this. Owning individual stocks is way riskier than owning index funds. Your initial investment may be decimated, and it may never regain its value. When I was a novice investor, way back in 2007, I bought a whole bunch of individual stocks. One of them was this random European shipping company. During the crash of 2008, the company lost more than half of it’s value. It’s been 10 years and it still hasn’t improved. I’m still holding onto it (because at this point it doesn’t really matter) but I doubt it will ever improve. However, the losses haven’t been realized yet, so there’s always the possibility (albeit slim) that the company will somehow turn itself around and I’ll recoup that initial investment. There’s also the possibility that the company will go bankrupt and I’ll lose everything I have in it. You win some you lose some.
Housing is a huge sector in which people don’t consider whether gains have been realized or not. People love to claim how much their house has risen in value and talk about how rich they are because their house is worth a pretty penny. But you can’t buy food with that money (unless you take out a home equity loan, which is a terrible idea!!!). You can’t actually make money on your house until you sell it.
That’s the reason why I wanted to move out of California. My house’s value skyrocketed! It was amazing! But I was still paying the same in mortgage, and the increased value wasn’t helping me financially in any way. I was sitting on a pile of unrealized gains. However, when I sold, I realized (and pocketed!) the gain. I wasn’t going to be left holding the bag when the housing market drops again! And It will, eventually. All markets have peaks and valleys.
I hope you aren’t taking away from this post that you should never sell. I’m not! Sometimes it’s prudent to take a loss. If an individual stock is plummeting and its fundamentals are poor, you may want to sell it before the company goes bankrupt, before you lose even more money, or if you aren’t happy with the amount of risk in your investment. Or maybe it’s time to diversify. There are plenty of good reasons to sell even in a down market. My point in writing this is to explain that losses (and gains too!) aren’t actually real until you pull out. No money is gained or lost until you sell your investment (again, unless the company goes bye-bye or something drastic happens – exceptions to every rule and all that!).