Understanding when a loss is actually crystallised
Contributed by Sani Hamid, Wealth Management Director, Financial Alliance Pte Ltd (The contributor can be contacted at firstname.lastname@example.org)
One of the most misunderstood concepts in investing is encapsulated in the question ”When does an investor crystallise his/her losses?”.
Many investors believe that, once they sell an investment, they are crystallising the loss of that particular investment.
That’s very true for someone who views every investment as a separate trade, e.g., someone who owns Stock A and B. A goes up 10% to make $100 while B goes down 10% to lose $100. The investor sells B and thus crystallises the $100 loss and moves on to search for Stock C with the remaining capital from Stock B.
Clearly, the objective of managing one’s portfolio in this way is to make a profit on each and every investment without considering the objective or time frame of that portfolio of investments.
Paper versus Crystallised Losses
However, this should not be the case when dealing with an investment meant to attain a certain objective or time frame, for example, one’s retirement or a 15-year period. In this case any “losses”, or even “gains”, within that time frame are not crystallised but merely deemed “paper losses/gains”.
Imagine an investor who has two holdings – Stock A & B – which he/she aims to hold for 15 years to retirement. After the 5th year, Stock A is up 10% and Stock B is down 10%. He/she disposes of Stock B with a loss of $100 and invests in Stock C.
Up to now, this is the same set of circumstances as the earlier example. But consider that such “switches” will continue for the remaining 10 years, at times resulting in paper losses and at times in paper gains.
At the end of the 10 years, the combined returns from his/her portfolio show a gain/loss and is withdrawn for the intended purpose (retirement). That is when one can say with certainty whether that particular investment (made 15 years ago) has made a gain or loss, because it is the point where the accumulated effects of the paper gains/losses are crystallised into real gains/losses.
In other words, each gain or loss made throughout the 15 years didn’t matter because what truly matters is the final Profit/Loss upon maturity.
“I will wait for it to breakeven”
Why is this understanding important? We often see investors unwilling to switch out from an underperforming investment. Instead, they prefer to stay with it until “it recoups all its losses to avoid crystalizing the losses”. This results in investors sticking to an investment, which in turn puts a drag on their overall portfolios. At the same time, they are missing out on opportunities which could provide a better chance of recovering the losses.
Another way to explain this is to imagine an investor putting all his money into a well-diversified balance unit trust managed by a fund manager (FM) and holding it for the next 15 years.
What does the FM do with the money over this 15 years? He/she will take it and invest into say 100 individual stocks & bonds. During these 15 years, the FM would at times take profit on some of these investments and at other times cut losses on bad bets. But would either of these actions mean the investor had crystallised his/her gains/losses?
Of course not. In fact, many of us wouldn’t be able to track the actions of FMs, i.e., whether they sold an investment at a gain/loss, given that buying and selling are ongoing activities throughout the life of the fund. All we care about is the skills of the FM to deliver upon the mandate of the unit trust fund, e.g., 6% per annum over the long run.
Thus, we all understand that we should only judge the performance of the FM and the fund itself at the end of the 15 years, and not with what is done in between. This is how one should view their own retirement portfolios or any portfolios that are time/event based. It’s not a bet on the individual funds within the portfolio but a bet that the overall portfolio itself will deliver in the time frame stipulated. And that can only be assessed at the end of that time frame.
When a “loss” becomes real
The ONLY time the FM would crystallise gains/losses in a fund even BEFORE reaching the end of the 15 years is if he/she decides to put all the investments into cash permanently. Once a FM or investor does not have the intention to participate in the markets anymore, gains or losses are crystallised and there is no way to make further gains or losses. This is akin to an investor pulling out of the market now out of fear with a 30% loss but with 10 years left before retirement. He then puts the remaining investment in a fixed deposit. In this case, “yes” the investment losses have been crystallised because there is no opportunity to recover the losses through further investments (they are only partially offset by the fixed deposit’s interest). This is when “paper losses” effectively become “real losses”.
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