Understanding Market Losses: Paper Versus Reality

August 03, 2023

In a volatile stock market, your emotions might let new highs and record lows drive your short-term decisions. The drastic ups and downs can make you feel confident one day and queasy the next. When your investment is reaching new highs, you might feel on top of the world. But, when your investment hits new lows, confidence wanes. The market's volatile nature might even lead you to jump ship on your savings goals. Unfortunately, this could cost you over the long term.

It's possible to remain calm during what feels like a financial roller coaster ride if you better understand market declines and the need for a smart investment strategy. When you pair the two, you're more likely to meet your financial targets.

Paper Losses versus Real Losses

Stock market dips are inevitable. When you remember this, you can avoid taking unnecessary actions in an effort to protect your money. Despite the growing difference between the current value of the investment and the amount you paid for it, remember that the loss only exists on paper. These are called unrealized losses and are a normal part of investing. Be patient and wait, remembering that since the stock market moves in both directions.

You lock in or realize losses when you sell your investments at a time they have dropped in value. Remember, as long as you own the investments, their market values will continue to fluctuate up and down. Given enough time, these regular dips and spikes allow you to recover from those paper losses.

The No. 1 Investment Strategy Tip

It's possible to avoid making fear-based decisions, even when you see your investment value plummet in a short timeframe. Follow an investment strategy that matches your time horizon and risk tolerance, and you'll be more likely to handle market swings. An investment strategy will also help you avoid placing funds into investments that are too aggressive or conservative based on your personal financial goals.

Time Horizon and Risk Tolerance

Whether you're investing money so you can live your dream retirement or help pay for your child's future college education, the date you'll need the money is a crucial factor in your investment strategy. Identify how much of those funds you're willing to risk and for how long. Once you know your time horizon, you can then consider different investments based on their level of risk.

For example, stocks are often recommended for investors with a time horizon of 10 years or more. If the money is needed in less than five years, consider more conservative investment accounts instead, such as share certificates, money market funds and high-yield savings accounts. While these options offer lower levels of return, it's unlikely that you'll lose your investment.

If your time horizon falls somewhere between five and 10 years, adding a mix of stocks and bonds to an otherwise conservative investment portfolio might give you the growth you need to achieve your financial goals. Bonds offer a consistent payout of interest and can help balance the risk of stocks.

The same market lows will likely affect investors in different ways. Net worth, initial investment amount, goals, and experience are all factors in each individual investor's risk tolerance. For example, an investor with a time horizon of 35 years until retirement will likely have a different emotional response than another investor who plans to retire in two years.

Key Points:

  • Shorter time horizons might lead you to invest in safer, low-risk investments, which often result in smaller returns.
  • Longer time horizons allow you to take greater risks since you may have more time to recover from market declines.
  • As the time horizon gets closer, expect to reduce your financial risk by adjusting your investment portfolio.