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 it’s dropped the most significant 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.
Are Capitals Gains Realized or Unrealized?
The first type of gain or loss that someone will experience with the stock market is capital gains or losses. Capital gains and losses represent the money you either make or lose when a stock you own fluctuates in value. When the value of the stock goes up, it’s a capital gain, and when it goes down, it’s a capital loss.
But the big secret is that neither of these things is 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. You also (generally) don’t pay capital gains tax until you realize your gains.
How Do You Realize Your Gains and Losses?
I mentioned making gains real a few times, and let’s take a second to talk about what that means. Realizing a gain or a loss means selling the investment and getting the cash value. When you sell, you are locked into whatever price you sold it for, and if the investment gains more value, you lose out on any of that. But it also means you lose out on further 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 bunch of money. If they stayed invested, the markets would eventually improve, and they would never have realized the loss. In effect, they wouldn’t 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 many individual stocks.
One of them was this random European shipping company. During the crash of 2008, the company lost more than half of its value. It’s been ten years, and it still hasn’t improved. I’m still holding onto it (because, at this point, it doesn’t 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 massive 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 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 mortgage, and the increased value wasn’t helping me financially.
I was sitting on a pile of unrealized gains. However, I realized (and pocketed!) the gain when I sold. 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.
Are Dividends Realized Gains?
Many index funds, mutual funds, and 401K plans re-invest your dividends, so it can be confusing to understand whether they are a realized or unrealized gain. Because a dividend is technically cash that you receive from holding an investment, it is considered a realized gain whether you roll it back into the investment or not. This is important because dividend income is taxable – so ensure you correctly report it.
Should I Re-Invest Dividends or Take Cash?
There is no correct answer to whether you should reinvest your dividends or take cash. I’m in growth mode -so my preference is to re-invest. This will help my investments grow more quickly over time. I’ll probably shift and take cash when I finally reach financial independence. The extra money will help me pay my bills when I’m job-free.
In my opinion, if you just started investing, you should re-invest. This will help your money grow as fast as possible, and the dividend amount will be so small that you will barely even notice it in your budget. Over time, you will see higher payouts as you purchase more and more stock, and waiting will be well worth it.
Be advised that there are always tax implications to these different things. You generally need to pay taxes on any investment income, whether capital gains or dividends. It’s best to speak to a tax professional about any tax consequences of buying and selling. Every situation is different.
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. Or you may want to sell a poor performer to offset your tax liability. 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 confirmed 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!). So don’t freak out about things that are happening on paper only. Keep investing, stay the course, and win big in the future!
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Melanie launched Partners in Fire in 2017 to document her quest for financial independence with a mix of finance, fun, and solving the world’s problems. She’s self educated in personal finance and passionate about fighting systematic problems that prevent others from achieving their own financial goals. She also loves travel, anthropology, gaming and her cats.