Investing in stocks is like riding a roller coaster. It’s up, it’s down, and suddenly you’re upside down, spinning in a whirlwind only to quickly come up again on top.
While riding the wave, it’s vital to understand the difference between realized and unrealized gains and losses.
Realized vs. Unrealized Gains and Losses: What’s the Difference?
Realized vs. unrealized gains and losses are the difference between really losing money or winning big versus paper wins and losses.
Beginner investors must understand the difference.
What’s a Realized Gain?
A realized gain is any gain in which you make real money. You get a real gain when you sell an investment, such as a stock, during a price increase and make money on the deal. The money goes into your bank account.
What’s a Realized Loss?
A realized loss is a genuine money loss. You have a realized loss when you sell an investment during a downturn and lose money on the deal. Because you sold, you no longer own the company and cannot get any of the lost money back.
What’s an Unrealized Gain?
An unrealized gain is a win on paper. One of your holdings increases in value, but you don’t sell it, so you don’t truly reap the rewards. There’s always the potential that it will go back down.
What’s an Unrealized Loss?
An unrealized loss is a loss on paper. Your investment takes a downturn, but you haven’t truly lost any money since you own the same amount. You only lose money when you sell, locking in the loss.
How Do You Realize Your Gains and Losses?
Realizing a gain or a loss means selling the investment and getting the cash value. When you sell, you lock into whatever price you sold it for.
You miss out on potential future gains but also protect yourself from future loss.
Realized vs. Unrealized Gains and Logic: When Emotions Battle Logic
The concept of realized vs unrealized gains and losses is difficult for beginner investors to wrap their heads around.
How can you lose money, but not really?
Logically, it’s relatively simple. You only win or lose when you lock in by selling.
Unfortunately, most people can’t control their emotions regarding money because they cannot afford a significant investment loss.
Watching your investment plummet in value elicits a visceral fear response we can’t control, especially when we don’t have much money to invest. Conversely, a massive financial gain invigorates us, and our mouths water in anticipation that all our financial problems are over.
These emotional reactions make us act irrationally. We sell when the market plummets, realizing the losses at the worst possible time.
As a Forbes report on the 2008 financial crisis and subsequent recovery explains, staying invested during financial turmoil (as long as you have a well-diversified portfolio) is usually the best course of action. Markets recover, but if you realize your losses during a downturn, it’s impossible to recoup them.
Selling is Not the Only Way To Realize a Loss
When discussing realized vs unrealized gains and losses, it’s essential to understand that selling isn’t the only way to realize a loss. You can also lose money when a company you’ve invested in goes bankrupt. There’s no longer anything to sell, and you’ve realized the loss on your entire investment.
Diversification is crucial to avoiding realized losses through bankruptcy or insolvency. If you’re invested in index funds rather than individual stocks, the odds of losing big due to bankruptcy significantly decrease.
No investment is 100% risk-free. There’s always the chance that funds will not recover or your financial management firm will file for insolvency.
Are Capitals Gains Realized or Unrealized?
Capital gains and losses represent the money you make or lose when a stock you own fluctuates in value. When the value of the stock goes up, it’s a capital gain; when it goes down, it’s a capital loss.
The big secret is that neither gains nor losses are confirmed until you make them real by selling (with the exception of insolvency, discussed above).
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. You also (generally) don’t pay capital gains tax until you realize your gains.
It Doesn’t Always Go Back Up
There’s no assurance that a company with paper losses will regain its value. Many companies lose value in a downturn and continue limping along at a lower level for decades.
As a novice investor in 2007, I decided to try my hand with individual stocks. I bought a European shipping company that looked good on paper to my beginner’s eyes. It plummeted in value during the 2008 market crash but lingered on for years at a lower value.
I eventually sold it as a loss to hedge my tax liability in a year when I realized substantial gains on a different investment.
Realized vs Unrealized Gains in Housing
Housing is a massive sector where realized and unrealized gains play a substantial role. People love talking about how much their home increased in value, bragging about their newfound net worth.
Those gains are unrealized until you sell. Housing markets ebb and flow like stock markets. They may be up today, but they could plummet tomorrow. You don’t get the gains until you sell.
Home Equity Loans
Of course, there are exceptions. If your home skyrockets in value, you could take out a home equity loan to reap the financial rewards without selling.
However, that’s typically a terrible idea.
Home equity loans are loans, meaning you’re putting yourself into debt and opening yourself to even more risk. If the housing market plummets again before you sell, you’ll be left owing far more than you can ever hope to pay off.
Are Dividends Realized Gains?
Dividends are payments companies offer shareholders as a profit share from the investment.
Many index funds, mutual funds, and 401K plans allow you to re-invest your dividends, making them seem like unrealized gains. However, a dividend is cash you receive from holding an investment, so it’s considered a realized gain whether you roll it back into the investment or cash it out.
Dividend income is taxable, so you must report it correctly to the IRS, except for dividend income from 401Ks. Retirement plans are generally tax-exempt until you retire (or cash out), so the dividends, although realized gains, are not taxable during your working years.
Tax Implications of Realized vs Unrealized Gains and Losses
Realized and unrealized gains and losses have very different tax implications.
Generally, you must pay taxes on any investment income, whether received through capital gains (investment increases) or dividends. You can also write off certain investment losses.
However, gains and losses are typically reportable only in the tax year they’re realized. If your index funds grow in value because the price increases, you will only pay taxes when you sell. If it grows in value due to dividend reinvestments, you’ll pay taxes on the income earned via dividends.
The US tax code regarding investment gains and losses is unnecessarily complex. There are different income tax rates for long-term capital gains versus short-term capital gains, dividend income versus investment income, and numerous exceptions to every tax rule. Savvy investors use loss harvesting to decrease their tax bills, as capital losses may be deductible.
You should speak to a tax professional about any tax liabilities you may incur due to investment gains and losses, whether realized or not. Every situation is different.
When Should I Sell?
Sometimes, it’s prudent to sell during a downturn to prevent future losses, and other times, it’s better to wait it out.
Deciding when to sell is a personal decision involving many factors, from your investment goals and tax implications to the investment’s potential and fundamentals.
Don’t let the idea of realized vs unrealized gains and losses prevent you from selling an investment when it’s in your best interest to sell. Speak to a financial advisor if you need help determining what’s right for you.
Unrealized Gains and Losses: The Takeaway
The essential thing to remember when investing is that paper gains and losses aren’t confirmed until you take action (bearing the exceptions discussed).
No money is gained or lost until you sell, so stop making emotional decisions based on a change. Before taking action, consider the potential long-term consequences.
Keep investing, even during downturns, especially if you’re well diversified. It’s the best way to secure your financial future.
HELOCs aren’t exactly terrible ideas. It usually depends on the timing and the use of proceeds. Whenever you are getting a big slug of money at a <5% rate, you are tapping into a pretty attractive source of financing. That's why the Use of Proceeds is crucial.
– Using it on a lavish vacation is a terrible idea
– Using it to invest in the stock market is risky (the two asset classes are correlated) but not a terrible idea
– Using it to fund a well thought out business venture is a better idea
I agree that there are certain circumstances in which a HELOC isn’t terrible, but I do think it’s pretty risky for novice investors. Thanks for the input!