Section II - Lesson 5A
Investing Basics - Understanding Risk: Paper Profit And Loss
Suppose for a moment that you own a home that you never intend to sell. You love this home and it’s perfect for your needs. Your children grew up in this home and it holds lots of wonderful memories for you. You and your spouse intend to live here for the rest of your lives.
You bought this home 40 years ago for a purchase price of $25,000 and made appropriate mortgage payments for 30 years. On the day you made your last mortgage payment you made note of the fact that your home had appreciated in value and was now worth about $200,000 on the open market. That was 10 years ago.
Here’s your question. If the housing market in your part of the country has really tumbled in the past few years and your house is now valued at only $150,000 in the open market, how much money have you lost?
The answer, of course, is zero, because you never intend to sell it. You didn’t intend to sell it when it was worth $25,000 or $100,000 or $200,000 and you don’t intend to sell it now. You no more have a “loss” of $50,000 than you have a “profit” of $125,000 from your purchase price. You have the same thing now that you had 10 years ago, and that’s a home that’s perfect for your needs that you don’t intend to sell.
Here’s your second question. What’s your risk of continuing to hold onto this home in the middle of this terrible housing market? The answer again is zero! If you never intend to sell it, you face no risk at all. Where would you live if you sold it, and how would this make you better off than you are now?
Here’s one final question. What are the chances that, given a little time, the market value of your home will rebound and continue to grow well past the $200,000 it was worth 10 years ago? Pretty good, wouldn’t you say, when you consider the fact that the price of real estate, along with the price of everything else in our lives, has always gone higher.
So what does all this have to do with risk as it applies to the stock investments in your two accounts? Everything, actually. Your investment program is like the home you’re never going to sell. It’s your “Castle”, so to speak, your refuge against life’s big and little financial shocks. You’ll tap your two accounts from time to time but you’ll never dream of “cashing them out.” Why would you ever want to do this? Even when you retire and take regular monthly withdrawals, these will be small amounts by comparison to the value of your whole account.
Like the home, in our analogy, your equity in your investment accounts is built up over the years by your regular monthly payments, and its value 30 or 40 years from now will bear no relationship to the small amount of cash you actually paid into these accounts. Market forces, along with inflation, will be the main determinants of this value.
The paper “profits” or “loses” that develop from year to year in your investment accounts are no more meaningful than the ones in our analogy, once you come to understand that you will never cash them out. You’re building wealth in accordance with a well thought out master plan, and the ups and downs of the marketplace should be of no concern to you.
If the market value of your accounts was $400,000 at the end of last year, but now only $350,000 due to a decline in stock prices, you have not lost $50,000. You’ve not lost anything, because you’ve not sold anything. And when the market straightens out, as it always does, and goes on to new highs, your big paper “profits” will be no more meaningful than this paper “loss.”
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