The goal of any investor is to make money, so whenever you see that one of your investments is down, it's natural to get a little anxious. But before you panic, remember that there's a big difference between an actual financial loss and a loss on paper. Also known as an unrealized loss, a loss on paper occurs when the value of an asset or security drops below its original price, but the investment is not yet sold. A realized capital loss, on the other hand, occurs when an investor sells an asset for a lower price than they initially paid for it. Knowing the difference between a realized loss and a loss on paper can help you sleep better at night as you keep tabs on your investments.
It's only on paper
While all investments come with a degree of risk, the stock market in particular is known for its tendency to fluctuate. You may buy a stock and then see it drop in value the very next day. But the important thing to keep in mind about stocks (and other investments) is that you only lose money when you actually sell your investments at a loss.
If you buy 100 shares of a particular stock for $50 a share and the price drops to $40 a share, then you haven't lost any money. Rather, the market value of your shares has simply declined. If you were to sell those shares at the current market price of $40, then you'd lose $1,000. But unless you actually unload those shares, the only loss you'll experience is an unrealized loss, or a loss on paper. And while it may be disheartening to stare at your account statement and see that number go down, you should know that if you're patient and level-headed enough to ride out price fluctuations, then your investments may rebound.
When it pays to sell
There are some situations where it pays to convert a loss on paper to an actual, or realized, loss. If you have a year in which you've sold a number of investments at a profit, then selling other investments at a loss can be beneficial from a tax perspective. The reason is that you're allowed to use capital losses to offset capital gains, but in order to take do so, you'll actually need to sell some of your poorly performing investments. You can't just point to a loss on paper for tax purposes, because in the eyes of the IRS, you haven't lost any money until you've actually sold.
Similarly, if you have a year when your taxable income has climbed and a few investments have declined in market value, you might consider selling off some investments for a net loss. You can claim up to $3,000 in net losses per year and use them to offset your ordinary income. Furthermore, if your net loss for the year exceeds $3,000, you can carry the remainder to the following tax year.
The next time you see one of your investments drop in value, do your best not to panic. Unless you need to cash out that investment right away, what you're seeing is simply a loss on paper. In reality, you won't actually lose a dime unless you sell.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!