Imagine a football game in which your team is down by a touchdown at halftime. Does that mean the game is over and you lose? Or maybe your favorite baseball team is down by a run going into the 7th inning stretch. Is that it? Is the game over? Of course not. At home, we always joke that we don’t even need to turn on the TV until the very end of the game. Remember the Yogi Berra quote, “It ain’t over, til’ it’s over.” The same thing is true when investing in the stock market.
For example, let’s assume we love the prospects of the new IPhone 6. We’re so excited that we buy 100 shares of Apple. A year from now, our Apple stock is up 5% from where we bought it. Have we made money? Yes, this is a trick question. The answer may be surprising. We really haven’t made anything yet. We have done well enough that we could sell Apple at a profit. But, unless we actually sell our Apple stock and take a profit – the “game” isn’t over. Our stock could drop in value at anytime. Maybe there’s a negative surprise, like a problem with Apple’s supply chain, or maybe IPhones are now easily hacked by a group attempting to steal Social Security numbers. Anything can happen, and many times it does.
I’m talking about the difference between realized and unrealized gains/losses. Realized refers to what happens when you actually sell a stock. Now you have the cash and are no longer exposed to the risk of owning the stock. Unrealized simply means you still own the stock. Any changes in price will affect the value of your holdings. The game isn’t over yet.
If you go online and look up your account, or maybe you take a look at your most recent account statement, all you’re seeing is a value if you were able to sell everything in your account at that particular instant. If you have no interest in selling everything in your account then your account value is more arbitrary than most people realize. By the time you’re seeing your account value, the reality is that your account value has probably already changed.
I’ve found that it is very important to have a plan regarding different scenarios that might play out before you ever actually buy a stock. The idea is that you are better able keep emotions out of your decisions. It is only too common that a stock will head lower, and emotions take over. One then sells to stop the bleeding, and locks in losses. The losses are then realized. Going back to our football example, it’s like quitting at half time. But what else can you do? You want to protect your account value as much as possible. Many investors deal with this by using a “buy and hold” strategy. If a stock goes down, they’ll just hold it and hope to ride it out. Which of these is the better strategy? Who knows? One only knows with hindsight. Luckily, we have a better way to deal with this type of situation.
I like to sell call options to generate income. This allows me to lower my breakeven point below my cost basis. This is a huge game-changer. If this were football, I then control when to time the end of the game. I can tell the referee that the game isn’t over, and we’ll add a fifth quarter if I want to. If we’re winning after the first quarter, I could declare the game over. I’m able to have much more control. Wild isn’t it!
I encourage you to check out the Learning Center on inspirecapital.com. There’s lots of great stuff there that will forever change your approach to investing.
Good luck. Invest Inspired!
For more information contact:
Michael P. McKee, CERTIFIED FINANCIAL PLANNER™
Inspire Capital Management LLC