March, 2008
The Second Opinion: The Myth of Paper Losses

Don’t believe it’s only a loss if you sell it

Why this is important: When investors don’t recognize that a loss is a loss, they may be underestimating the risk of their portfolio as a whole and they may be postponing important adjustments to their portfolio and lifestyle.

As already discussed, a loss is a loss. A paper loss is a loss that has not been recognized by selling the investment. Novice investors are sometimes prone to denying reality by not recognizing a loss. Also, financial advisors, when facing angry clients, might be tempted to encourage the belief that paper losses are nothing to be concerned about. It may not be a loss for income tax purposes until you sell it, but it is definitely a loss in terms of calculating your net worth.

Living under this illusion can be a problem because it may cause you to delay making important decisions. Often, the right thing to do is to take corrective action as soon as things start to go wrong. A saying in the industry suggests that your first loss is often your best loss.

Like all myths, this one has some grounding in reality. The value of an investment fluctuates every day and a small loss may indeed be recovered the following day. That the investment may rebound tomorrow does not, however, indicate that a real loss has not occurred today.

When you call a loss a loss, you recognize your mistake. Being aware of a mistake is more likely to lead you to corrective action.

Unfortunately, investors, like most people, don’t like to recognize mistakes and often will grasp at any straw to avoid facing reality. I know of one investor who had almost 50% of his assets invested in Cisco when it was trading at $65 per share. When Cisco dropped to $15 per share, common sense suggested that he should reduce his retirement spending plans. Yet, he clung to the belief that it was only a paper loss and, since paper losses don’t matter, he continued with a higher level of spending than was sustainable in view of his reduced circumstances. By clinging to this false hope, he further damaged his future financial security.

The stock market shows you the true value of your investments. When value increases, they are bid higher. When value decreases, they are marked down. This is the way the industry reports gains and losses. It should also be the way you recognize a loss when it has occurred.

Bottom line: If something was worth more when you purchased it than it is today, you have lost money.

What you can do now: Forget the idea that a paper loss is less serious than a realized loss. Start measuring your net worth based on the true value of what you have today, not on some fantasy that distinguishes between paper losses and real losses.

The Myth of the Unrealized Capital Loss

Ken Hawkins

Introduction
One of the biggest mistakes made by the professional and retail investor alike is selling at the wrong time or not selling at all. This is especially true for stocks that have fallen below their purchase price. One of the reasons for this is the belief that until a stock is sold, and the capital loss is realized, it is not a “real” loss, it is only a “paper” loss or unrealized loss.

Many investors do not want to admit that they made a mistake, and until they sell the stock, no mistake was made, because they have not lost any “real” money yet. This rationalization prevents investors from taking the necessary corrective action to sell the stock at a small loss. Refusing to do so often leads to further declines.

Definition of a Loss
A definition of a realized capital loss is straightforward. A loss is recognized when assets are sold for a price lower then the purchase price. However, whether a “paper” loss is treated as a “real” loss is dependant on the perspective of those who view it.

Through the eyes of the tax man, or CRA (Canadian Revenue Agency), a “paper” loss only becomes “real” when the asset is sold. The eye of an accountant sees the loss differently.

Accountants will write-down the value of an asset from the company’s books when a return on the investment is unlikely. They will effectively “realize” a loss, even though the asset has not been sold. Recently the banks have taken huge write-offs on their ABCP (asset-backed commercial paper) assets, realizing they have lost much of their value and are not likely to provide a return on their investment. The “loss” was realized even though the assets were not sold. Investors still holding Nortel stock from 2000 are not likely to get a return on their investment and they should recognize their loss. However, to realize the loss for tax purposes, the stock in most cases has to be sold.

Investors do not like admitting they made a mistake
By avoiding selling a stock at a loss, investors avoid admitting their error in judgment. Under the false illusion that it is not a loss until they sell it, they elect to continue to hold a losing position. In doing so, they avoid dealing with the regret of their bad choice. Many investors will try to avoid admitting their mistake by holding on to the stock and hoping it will recover.

In many cases this decision is not based on any rational analysis but rather is based on their false hope. Unfortunately, many of these same stocks will continue to slide lower.

Realizing Capital Losses Before They Get Larger
Sometimes you just have to bite the bullet, take your lumps, and sell your stocks at a loss before the loss gets bigger. The first thing you do is to realize that hope is not a strategy; there has to be a logical reason why you should hold onto a losing position. The second thing to understand is that the only person who cares what you paid for a stock is yourself and maybe the tax man (or tax woman). What you paid for a stock is irrelevant in determining its future direction. The stock will go up or down based on forces in the stock market and the underlying fundamentals and future prospects of the stock you are holding, not based on the price you paid for it. The price you paid is irrelevant to its future prospects.

Some of the ways of assuring a small loss does not become “dead” money or a larger loss follows:

  • Have an investment strategy: A written investment strategy that provides a set of rules both for buying stocks and selling stocks will provide the discipline to sell stocks before a small loss turns into a large loss.

  • Have reasons to sell a stock: An investor always has many reasons why they bought a stock, but typically no reason why they should sell it. Have a reason to sell stocks. It could be news on a corporate development, or a price target, etc. Have a strategy in place if the company releases bad new.

  • Would you buy the stock?: On a regular basis review every stock you hold and ask yourself the simple question- If I did not own this stock would I buy it today? If the answer is “I would not touch that stock with a 10-foot pole”, then it should be sold.

  • Tax loss harvesting strategies: A strategy to realize capital losses on a regular basis provides some discipline against holding losing stocks for extended periods of time. At best many of these stocks become dead money, and at worse many continue to drop even lower. Even selling stocks at a loss can be put in a positive light because you are receiving tax credits (i.e. capital losses) that can be used to offset taxes on capital gains. When a stock is sold the realized losses become assets that previously had no value when the loss was only a paper loss.

Bottom line
A loss is a loss is a loss, whether you realized it by selling the stock or continue to hold a losing position. Taking corrective action before the losses worsen is always a good strategy. In investing, we can not avoid the losses. Successful investors realize that, and they try to minimize their losses, not avoid them. Selling a stock at a loss and receiving a tax credit is one benefit you will receive. Selling the “dogs” from your portfolio has an added advantage. Removing them from your portfolio, you will not be reminded of all the past mistakes you made every time you look at your investment statement.