Are market changes real, or are they more like dreams?
Dreams of World War 1 soldiers, by Jan Styka. Source: Lublin Museum
There’s a common thought that market gains or losses aren’t real gains or losses – they’re only “on paper” until investors sell their holdings, 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 IBM went from $100 to $200 per share, that gain was real. And when it dropped back to $140, that loss is real. The company’s value is different than it was a year ago. When we calculate total return we incorporate these price changes.
But there’s a sense in which the common sentiment is accurate. Our gains and losses are realized when we sell, and we’re required to report these on our taxes. The 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.
Photo: Steve Buissinne. Source: Pixabay
But there’s another sense in which the common sentiment is true: when we change our asset allocation in response to the market’s gyrations, we take fluctuations in value 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, like trimming a position to stay inside of our 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 Tempest, the main character Prospero tells his daughter that “We are such stuff as dreams are made on, and our little life is rounded with a sleep.” Life is fragile, and what’s here today is gone tomorrow. It’s true with our money, and it’s true in other things, too: much of what we experience is “but a dream.”
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”