With continued market volatility partly due to rising interest rates, inflation and an uncertain economic outlook, investors need to make sure they understand the difference between a real and paper loss. The following article will distinguish these two losses and provides investors with some tips on how to reduce the chances of crystalising capital losses when faced with challenging market conditions.
What is the difference?
Paper Losses
A paper or an unrealized loss is one that is due to the decrease in the capital value of a particular investment over time which can be characterised as a loss in value but not necessarily in profit. What makes these losses different is that if they are not sold at this decreased price, then no loss has been realised or ‘crystallised.’
Over the course of a long-term investment horizon, it is inevitable that investors will experience paper losses and it is important that these do not form the basis of irrational decisions and this is likely going to lead investors to sell assets for less than they were purchased.
Capital Losses
A capital loss occurs when an investor purchases a particular holding such as a stock for a price that decreases in value over time and is sold at this lower price. The differential between the purchase and sell price is the loss that an investor has to bear. This is the kind of loss that all investors are trying to avoid and there are a range of strategies that individuals can implement to minimise the risk of crystalising these losses.
The first approach is to hold. This refers to maintaining current investments irrespective of market downturn which will help to prevent investors from making emotionally charged decisions and potentially mistakes based on the panic they feel when they see their investments have fallen in value. Investing is all about time in the market and thus remaining invested is one of the best strategies investors can adopt to reduce their losses over the long term. Research from Russell Investments has suggested that a balanced portfolio of both equities and bonds has not produced a negative return over any five-year period rolling since 1979. Hence, before acting investors should consider whether their decisions are being motivated by logic or emotion as well as the benefit of allowing their portfolios to recover during market volatility. To read more about the benefits of staying invested, click here.
Diversification is another important tool that investors should acquaint themselves with in order to reduce the potential of capital losses being realised. Diversification is an important risk management strategy which is basically what investors call ‘not putting all your eggs in one basket.’ This entails holding a range of investments from both assertive and defensive asset classes, across different sectors, in both domestic and international markets. This will help to reduce the effect of volatility on your portfolio as particular holdings may be more impacted by market downturn compared to others, and therefore having a wide range of investments should be a consideration for all investors.
Investment time horizon
Another way investors can help their portfolios to recover prior to crystalising their losses is through taking a long-term approach. Long-term investing encompasses holding certain investments for an extended period of time with minimal changes during both market downturn and market growth. This involves allowing your investment account to grow over many years instead of reacting to short-term volatility or noise that occurs on a day-to-day basis. Being a long-term investor is often associated with bearing more risk and therefore increased returns as you have time to weather falls in the market.
Another key consideration is maintaining sufficient cash outside of your investment portfolio to cover any emergency or ad-hoc expenses. This will help to prevent investors from being forced to liquidate their investments during market downturn and realising a capital loss as they have adequate cash supplies to supplement their income.
If you would like to improve your current investment strategies or are looking to start your investment journey, click here to organise a complimentary 20-minute phone call with an EPG Wealth adviser.