Are market changes real changes?
Dreams of World War 1 soldiers, by Jan Styka. Source: Lublin Museum
There’s a common understanding that market gains or losses aren’t real gains or losses—they’re only “on paper” until the investor sells the stock, making them “real.” But that’s a cognitive error—a kind of egocentric bias that says that something is only real if it affects me. In fact, price changes are real changes. When Apple goes from $100 to $200 per share, that gain is real. And when it drops to $170, that loss is real. Our portfolio’s total value has changed. When we calculate total return we incorporate these temporary changes.
But there’s a sense in which the common sentiment is accurate. Our gains and losses are realized when we sell, and we have to report them on our taxes. Those tax consequences are quite real: money paid to the IRS isn’t coming back. That’s why tax-losses become an “asset” in the topsy-turvy world of tax accounting.
But there’s another sense in which the common sentiment is true: when we alter our asset allocation in response to the market’s gyrations, we take temporary changes in valuation and make them more-or-less permanent. That doesn’t happen when we sell one stock and buy another. We’re not taking money off the table, we’re just changing where we place our bets. But when we shift from stocks to cash (or short-term bonds), we go from a higher-risk asset to a lower-risk asset. That can be for good reasons—say, trimming a position to stay inside of policy limits—or bad ones—like selling out when the market’s volatility scares us. But our behavior can turn temporary gains and losses into permanent changes in a portfolio’s value, depending where we put the proceeds.
In Shakespeare’s play The Tempest the main character Prospero tells his daughter and her fiancé that “We are such stuff as dreams are made on, and our little life is rounded with a sleep,” (Act IV, Scene 1). Life is fragile, and what’s here today may be gone tomorrow. It’s true with our money, and it’s true in other things: much of what we experience fades when we touch it. Much of our life is “but a dream.”
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”