If You're Investing in the Stock Market, You Need to Understand This Important Concept

When the value of your investments goes up, it's natural to assume that you've made money. By the same token, when their value goes down, you might think that you've lost money. Lots of investors look at it this way, especially those who are new to investing, but this is actually a common mistake.

The reason you haven't really made or lost money ties into the concept of realized and unrealized gains. Here's what these terms mean and why it's important to understand them when investing in stocks.

Realized vs. unrealized gains

Let's say you invest $1,000 in a stock. After one year, it has increased in value by 10%, so it's worth $1,100. You would have $100 in unrealized gains. The investment has increased in value, but you haven't sold it at that higher price yet. You also wouldn't need to report those investing gains on your taxes.

If you sell your investment for $1,100, you now have $100 in realized gains. You would need to report them and pay capital gains tax.

Investments you hold for longer than a year before selling are considered long-term capital gains. Investments you sell within a year are short-term capital gains and taxed as ordinary income. Long-term capital gains have lower tax rates than income taxes, so it's advantageous to hold investments for longer than a year.

To sum it up, realized gains are the profits you make when you sell an investment. Unrealized gains are profits that you've made on paper but haven't locked in yet by selling the investment.

Realized and unrealized losses work the same way

This concept also applies to investing losses. If you invest $1,000 in a stock, and its value drops to $900 a year later, you would have $100 in unrealized losses. If you sell, then those become $100 in realized losses.

A common piece of investing wisdom is that you haven't lost any money until you sell. You may have on-paper losses, but if you continue to hold your investment, it could rebound. While that doesn't mean you should hang on to every loser in your portfolio, if you think a stock is a sound investment, give it time to recover.

Why the concept of realized and unrealized gains is important

Having an understanding of realized and unrealized gains is important so you can make the best investment decisions for your taxes.

Unrealized gains are a huge advantage for long-term investors. No matter how much your investments increase in value, you don't need to pay taxes on your unrealized gains. That's one of the reasons why buying and holding quality stocks is such an effective strategy. You can build more and more wealth without increasing your tax liability.

A frequent mistake of new investors is realizing gains too quickly. For example, their $10,000 investment in a stock goes up to $11,000, so they sell. This is an example of short-term thinking, which is what you want to avoid. That stock could be worth twice as much 10 years down the road. By selling too soon, you give up future value for quick cash. You'll also need to pay taxes on that $1,000 profit.

The thing to always keep in mind is that investing is for long-term wealth building. Your main focus should be regularly putting money into quality investments. These can be funds that invest in a large number of stocks, such as exchange-traded funds (ETFs), or individual stocks you pick yourself.

You shouldn't need to sell investments too often, unless you no longer believe a stock is worth owning. Otherwise, it's usually better to sit back and let your investments grow.