Unrealized Gain

Unrealized Gain (also known as a 'paper profit') is the increase in the value of an asset that you own but haven't sold yet. Imagine you bought shares of “Awesome Inc.” for $100. A year later, you check your brokerage account, and the stock's market price is now $150. You have a $50 unrealized gain. It's a 'gain' because your investment is worth more than its original cost basis. It's 'unrealized' because you haven't sold the shares to lock in that profit. The money isn't in your bank account; it's still tied up in the investment, fluctuating with the market. Until you sell, this profit is purely theoretical—it exists only on paper (or, more likely, on your screen). This is the opposite of a realized gain, which occurs only when you sell the asset and turn that paper profit into actual cash.

It's human nature to look at a large unrealized gain and feel like a genius. Your $10,000 investment is now worth $25,000! You start mentally spending the money—a down payment on a car, a lavish vacation. This is where danger lurks. Behavioral finance teaches us that these paper profits can lead to poor decisions. The endowment effect might kick in, causing you to overvalue the stock simply because you own it, making it hard to sell even when it's logically the right time. Conversely, you might fall for the disposition effect, snatching a small profit too early out of fear it will disappear, while letting your losing investments languish in the hope they'll 'come back.' Remember, an unrealized gain is like a winning lottery ticket you haven't cashed. Until you do, it's just a piece of paper with potential.

Here's the good news. One of the biggest advantages of unrealized gains is their tax treatment. You do not owe any capital gains tax on your profits as long as you hold the investment. The tax bill only comes due when you sell the asset and 'realize' the gain. This is a powerful concept for long-term investors. By holding on to your winning investments, you allow your money to compound tax-deferred. Furthermore, when you finally do sell, the tax rate often depends on how long you held the asset. Gains on assets held for more than a year are typically taxed at the lower long-term capital gains rate, while those held for a year or less are hit with the higher short-term capital gains rate, which is usually the same as your ordinary income tax rate. Patience, in this case, is not just a virtue; it's a tax-saving strategy.

To a true value investor, an unrealized gain is pleasant confirmation, but it's not the main event. The goal isn't just to see the price go up; the goal is to buy a great company for less than its underlying worth, or intrinsic value. The legendary investor Benjamin Graham personified the market as a moody business partner named Mr. Market. Some days he's euphoric and offers to buy your shares at a ridiculously high price (creating a large unrealized gain), and other days he's depressed and offers a pittance. A value investor, as famously championed by Warren Buffett, doesn't get swept up in Mr. Market's mood swings. The unrealized gain is simply a sign that the market is starting to recognize the value you saw all along. The focus remains on the business's performance, not the stock's daily dance.

So, if we don't sell just because the price is up, when do we sell? A value investor sells for strategic reasons, not emotional ones. The decision to convert an unrealized gain into a realized one should be based on your original investment thesis. Consider selling when:

• The Price Exceeds the Value: The stock has become significantly overvalued. Mr. Market is now offering you a price that is far more than the company is fundamentally worth. It's time to graciously accept his offer.
• The Thesis is Broken: Your original reason for buying the stock is no longer true. Perhaps a new competitor has disrupted the industry, or the company's management has made a series of poor decisions. The fundamentals have changed for the worse.
• A Better Opportunity Arises: You've found a different investment that offers a much better risk/reward profile. The potential return from this new idea is so compelling that it justifies selling your current holding, even if it's a winner. This is a calculation of opportunity cost.