How to handle unrealized gains and losses
Reading time: 6-9 minutes (1.669 words)
Unrealized gains and losses are profits and losses that will be realised when you would sell the asset for the current market price. Probably the biggest thing that can cause a emotional mindfuck while trading or investing are unrealized gains and losses. This even goes beyond trading and investing.
Unrealized gains and losses only live on paper. They become a reality once you sell your asset. Unrealized gains can quickly become a mindfuck and you will encounter this sooner than later when you start trading or investing. And this goes both ways:
- When you have unrealized gains, most people get greedy and want more
- When you have unrealized losses, most people get fearful and sell their positions at the wrong time
For example, if you buy stock X for $10 and the price moves up to $15 you have an unrealized gain of $5. If the stock drops to $5 you have an unrealized loss of -$5.
|Share price||Unrealized gain / loss|
|$10 goes up to $15||$5|
|$10 drops to $5||-$5|
You don’t have to report any unrealized gains for taxes but once you sell your position, your gains or losses are taxable. So in practice, unrealized gains or losses is not a hard concept to understand. The hard part is handling unrealized gains when you invest your hard earned money.
The psychological aspects of unrealized gains
While unrealized gains and losses happen every single day while trading or investing, it’s also common when you own a house. During the financial market crash in 2008 housing prices collapsed. If you owned a house, your mortgage was more expensive than the money you would get for your house if you sold it. In other words, many people had unrealized losses on their house.
While it sounds bad on paper (seeing the value of your house drop by $100,000 is no fun), it’s not that bad. It only becomes a problem when you are forced to sell your house for whatever reason. But the opposite is also true. It’s nice to see your house went up $100,000 in value. But you’ll only enjoy that profit if you sell your house. And if your house went up $100,000 in value, other houses are up in value as well.
Many starting trading and investors have trouble to really understand unrealized gains and losses. Not because they don’t understand what it means but how to handle the situation. It might sound obvious on paper to take your profit when prices go. But most of the time the thought process goes something like this:
- You bought stock/crypto X for $100
- Prices moves up to $120
- “Nice, let’s see where this is going”
- Prices moves up to $150
- “This thing is going up, I’m going to wait a bit more…”
- Price moves up to $165
- “Still not selling, might go up even further! Hype!”
- Price drops back to $150
- “That’s ok, price might go back up, were are still bullish”
- Price drops to $120
- “Hmm, did not expect that. I’m still in profit so that’s fine”
- Price drops to $100
- “Ehh, ok I hope it does not drop much further”
- Price drops to $75
- “Omg, I'm already 25% down…”
- Price drops to $50
- “Ohh my, this might even drop further… Should I sell and take my losses?
One of the first general rules of trading and investing is:
Don’t aim for the stars. It won’t happen. Always take a piece of the pie instead of wanting the whole pie. The funny thing is that most people would actually sell their entire stack if their asset went up 100%. But once you see that actually happening you start to wonder if the price might go up even more.
There are many people who held bitcoin in the very early stages when bitcoin just started. They now regret selling their bitcoin for $1 a piece now knowing the price went all the way up to $70,000. But that does not make any sense. Like all these people would have nerves of steel and ride the thing out all the way up to $70,000. The vast majority sold their coins much sooner. Only a lucky few held on to their coins. But be aware that holding on to something unknown can also be very dangerous. The number one reason to never invest money you can’t lose. Chances that bitcoin would drop to zero was bigger than rising to $70,000 at that time.
Other people bought in at $50,000, seeing the price going up all the way to $70,000 but now staring at $20,000 and hoping that price won’t drop any further. A crucial part in handling unrealized gains or losses is to come up with a plan before the market turns against you. You can do this in multiple ways:
- Determine if you are in for the short or long term
If you are in for the long term, the current price should not bother you that much. You only have to figure out if the current price is reasonable. If you really believe in the project or company you can buy in and hold it for many years or even decades. Nobody knows how that will turn out but if you stick to this plan it becomes easy to emotionally detach yourself for unrealized gains or losses. You would probably buy even more if the price drops because you are in for the long term anyway.
- Buy and sell at set price intervals
Handling unrealized gain becomes easier If you buy and sell at set price intervals. For example, you bought bitcoin at $20,000. You think the price will rise in the future but because there is an impending overall bear market you decide to first buy some more if the price drops below $18,000. And even some more if the price drops further. Once the market reverses you sell when the price hits $25,000 and some more when price hits $27,000 etc.
The reason why this works is because instead of spending all your money at once at $20,000 you buy in at an average. Even if the price dropped to $10,000, your average buy-in price would be $15,000 vs $20,000 if you invested all at once. So you still have unrealized losses but they are more manageable.
- Think about the asset you are holding instead of the current price
Anything related to investing or trading requires you to do your due diligence. In other words, it’s your job to find out if the asset you want to buy is a good buy. You only know what you know but with hard work you can determine if the asset is healthy or not. When the price drops, that does not mean the fundamentals of the asset changed. For example, bitcoin dropped 50%+ from its all time high. But that is not because there is something wrong with bitcoin. The fundamentals are still very strong. The price of bitcoin is determined by more things than just the fundamentals of bitcoin. If people have less money to spend they tend to pull out of riskier markets more quickly.
Sometimes you need to get out
Don’t be fooled by the fact that unrealised losses only exist on paper. The fact is, one day or another these unrealised losses:
- Need to turn around in gains
- Will stick in your portfolio forever hoping things will turn around
- Need to be sold to take your losses
Another emotional trap when trading or investing is not knowing when you should let go of your investment. Hoping that things will turn around will get you nowhere. You need to have a fundamental basis of why you are holding on to trades or stocks that are causing unrealised losses.
Maybe you are in for the long term. That might be a good strategy but only if the fundamentals of the business supports it. And there must be a place in the future for that business. Holding on to something just because you bought it does not mean you should hold it forever. Sometimes it does not make sense anymore. You have to take your losses or expand your strategy. For example waiting for five - ten years for things to turn around. Consider your money lost in this case.
You will eventually pick a losing trade or investment. That happens to literally every trader or investor. It’s your job to find out if it makes sense to still have that stock in your portfolio. Investing is not only about past fundamentals but also projections on the future. What will the market look like in a few years?
For example, there is a big shift happening in the automobile business. Every company is switching to EV (electric vehicles). Companies that are late in the transition might suffer in the future. With covid around, more and more information hits about a new digital age. A digital age where your passports and other things are connected through a QR code based system. So they can track your identity, see where you spend your money and what places you checked in. This requires massive amounts of data so technology companies seem to be in a good spot.
And for you unrealised gains it’s the same thing. You can’t expect that things will go up forever. Bitcoin is a great example. It went up from $20,000 to almost $70,000. You might have bought in very low but if you did not sell anything you’re now in a losing position as bitcoin went below $20,000 the last few days (june 2022). Take your profits. Don’t be greedy.
[keypoint text = Key concepts:
- Unrealised gains and losses can cause many emotional reactions causing you to make mistakes
- When you have unrealized gains, most people get greedy and want more. Don't be greedy,
- When you have unrealized losses, most people get fearful and sell their positions at the wrong time (have a plan and stick to it)
- One way or another, unrealised losses have to turn around at some point or you have to take your losses.
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