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Seller’s Remorse? How Dumping Investments in a Down Market Locks in Losses

Mar 18, 2020 3 min read John Renz

Key Takeaways

  • Short-term moves can undercut a long-term strategy.
  • Unrealized losses are only “on paper” and can be recovered with a market uptick.
  • Realized losses are for real and can’t be recovered if the market improves.

 

 

To sell or not to sell? That is the question in a falling stock market.

When markets are up, investors typically feel confident in their decision to invest. But when markets turn down — or, as with the recent coronavirus pandemic, way down — many get nervous and rethink their decision, even if it was part of a sound strategy. Problem is, that stress can lead to yet another decision investors may come to regret: Selling before (they believe) the market falls even further.

The reason: Unloading an investment that’s worth less than you paid for it turns a “paper” loss into a real one. And that can have consequences you didn’t intend.

So before you make a move, it pays to understand the concept of “unrealized” and “realized” losses (or gains) and how they might affect your finances.

 

Realized and unrealized gains and losses

When you invest in stocks — through individual companies or through mutual funds or ETFs — you buy shares. The value of those shares can change for a variety of reasons. But in general, when broad swaths of the market rise or fall, those shares follow suit.

While you own those shares, any gains or losses you experience are “unrealized” — they show up on your statement, but not in your bank account. They’re not exactly meaningless. But other than affecting your ability to borrow against them (if you have a “margin” account at a brokerage), and maybe your stress level, they don’t mean much in the long run — you’re still invested, and your investment could still rise (or fall) in value.

But once you sell, you “lock in” your losses (or gains) and they become “realized.” Besides getting paid, in the short term that means you’ll owe federal capital gains tax (if you made money) or can deduct the loss when you file your tax return.

Long term, the sale could have a much bigger effect on your financial health. If you’re investing for a far-away goal like college or retirement, your investment won’t be there for the rebound. That’s important to know because, historically, the market’s best returns have come on a relative handful of days. If you miss those, your losses will be even harder to make up.

 

A hypothetical look at losses, unrealized and realized

 

A hypothetical look at losses, unrealized and realized
Short-term pain, long-term gain A bigger hole to dig out of
In January “Barbara” invests $1,000 — she buys 1,000 shares of a stock at $1 per share. In June the market falls and the value of her stock plunges 50%, to $.50 per share.
Immediate result: an unrealized loss of $500.

Even so, Barbara is investing for retirement, which is decades away. She doesn’t sell because she wants to keep the potential for gains if the market rebounds.
In January “Kevin” invests $1,000 — he buys 1,000 shares of a stock at $1 per share. In June the market falls and the value of his stock plunges 50%, to $.50 per share.
Immediate result: an unrealized loss of $500.

Kevin is investing for a family vacation — in August. To avoid more short-term losses, he sells his shares and pockets the $500 they’re worth. He now has a realized loss of $500 (which he can deduct when he files his taxes). But if the stock price rebounds, he won’t be able to make back any of his loss.

 

What you can do next

Make the choice that’s right for your goals, and don’t let emotions rule your decisions. If you’re investing for the long term, stick to your strategy. And be mindful that if you sell while your investments are down, you’ve “locked in” your losses — and if you’re not in the market at all, you could miss a handful of key opportunities to make your money back (and then some). Yes, investing is risky, and you can lose money. But if you plan properly you could end up in better shape than you, well, realize.

 

Footnotes

John Renz is a vice president in the Content Center of Excellence at Prudential.

 

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