Are you a chicken counter or the boy who cried wolf?
The Sterling Report
How often have you heard someone say, “I made so much money in the stock market today”? I personally hear it almost daily, especially with the stock market doing so well in recent times. When someone says that, I always get worried because it is usually not true.
Before you crucify me, I am not saying that these people are liars. They have just fallen victim to a common misconception when investing — that you make money when your investments go up in value and you lose money when they go down. So widespread is this misconception that even your smartest friends and acquaintances are likely to be heard uttering those often misleading words.
If I get the opportunity, I always ask the person making that statement to elaborate to see if they really are making money. They will usually respond and say something like, “I bought XYZ share when it was selling for $5 a share and it is now up to $10 per share. I have doubled my money!” I usually follow up and say, “That’s great news! Have you sold them?” If they haven’t sold them yet, I remind them that the truth is, if your gain is only on paper you have not gained any money. Nothing is set in stone until you actually sell. Sorry to rain on your parade.
On the flip side, I also often hear people lamenting how much money they have lost. They will say something like, “My bond price has fallen so much since I bought it! I am losing so much money!” In a scenario like that I will usually calmly ask, “Have you sold the bond?” If they have not sold it, I use the opportunity to calm their fears and remind them that they therefore haven’t lost any money. At least not yet.
In down markets, investors are often overcome by their “loss aversion” instincts, thinking that if they don’t sell, they stand to lose more money; however, with bonds and stocks you do not actually lose money unless you sell at the lower prices. The key is to determine whether the decline in price is due to general market conditions, or to a deterioration in the credit dynamics of the issuer of the bond, which could be a precursor to a default.
This is why we always caution our investors not to worry too much about cyclical declines in the bond or stock market. If you are a long-term investor, you will likely have many opportunities over the years to sell at a profit. And in the case of a bond investor, you don’t actually have to sell your bond to make money. You can enjoy the scheduled interest payments and hold the bond to its maturity, at which point the principal is supposed to be repaid.
The analogy I often use to illustrate the point is: Imagine that you bought a house valued at $10 million and rent that house for $100,000 per month, and the value of the house goes up to $15 million. You could realise a gain of $5 million, but only if you sell the house. Otherwise you are just sitting on a potential $5-million gain.
Similarly, if the value of the house went down to $8 million, you aren’t actually losing money. You would only realise that $2-million loss if you sell the house. If you do nothing, you still have the house and you are still earning rental income (all things being well). Hence, the terms “unrealised loss” and “unrealised gain”.
The house in this analogy is like a bond or stock, and the rental income is like the bond coupon payments or the stock dividend payments.
In conclusion, as an investor it can be nerve-wracking to watch your portfolio’s value drop and thrilling to watch it soar. But the important thing to remember is that you don’t actually make or lose money until you sell your investments. I will leave you with two well-known sayings to help you remember today’s advice: “Stop counting your chickens before they hatch” and please don’t be “the boy who cried wolf”.
Toni-Ann Neita is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jmFeedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org