Time and time again, whether we are referring to those who dabble in more exotic assets such as Chinese options or those who prefer limiting themselves to trails that have already been blazed many times over, investors and traders make the mistake of not understanding the vital distinction between “paper profits” and gains that found their way to the proverbial real world.
To illustrate this, we will assume an investor bought a Chinese share at a price of $100 each and held for 5 years, collecting dividends which amounted to a grand total of $30 (we will assume he actually withdrew those and did something else with the $30 in question). Aside from that, we will also assume that the stock in question went up each and every year since our investor acquired it and is sitting at a more than respectable level of $500.
The investor in question loves counting his profits before going to bed each night, greedily scratching his hands as he thinks about the fact that he paid $100, already withdrew the $30 represented by dividends and his share is now worth $500. In other words, after subtracting the $100 he paid from the share from the $500 market price and adding $30, we are left with $430 in gains… are we not?
No, not really.
For the simple reason that most of those gains are just there on paper… unrealized gains, in other words.
- The $30 represented by dividends are indeed gains he actually withdrew and, frankly, the only ones which “count” at this point in time
- The remaining $400 are paper gains or, in light of the fact that trading is primarily an online endeavor at this point, perhaps calling them computer screen gains would be more accurate. Yes, he sees them on his computer screen whenever he logs into his brokerage account but he didn’t sell and until he does, they are unrealized gains and nothing more
If he were to sell right away, then indeed, he could calculate his ROI (return on investment) by dividing the actual profit by the $100 he has initially invested. We calculate this actual profit by adding $30 to $500 and subtracting the $100 invested initially from this amount. In other words, his ROI would be $430/100, or a more than impressive 430%.
Many investors in this situation, however, make the mistake of falling in love with the asset they have invested in and believing only good times lie ahead. As such, we see examples of people riding even an entire bull wave completely but never selling, with them being caught off-guard by an eventual bear market and either left holding the proverbial bag or pocketing considerably less profits than they could have.
In our case, perhaps a bear run is just around the corner, one which brings the price all the way down to $200. Should the investor only sell at that point, the ROI becomes ($230-$100)/$100, a still-respectable 130% but considerably less than the 430% his pre-bedtime accounting indicated, most likely considerably less so than what he believed his future ROI would look like.
Words cannot begin to describe how important it is to be firmly entrenched in reality when thinking about your ROI or potential ROI.
Time and time again, we have made it clear that most traders, the overwhelming majority in fact, lose money. This statement is so widely-accepted that we can consider it quasi-axiomatic but by all means, do not take our word for it: there are more than a few studies which prove just that or, as a less academic approach, we would recommend simply taking a look at some promotional banners for various brokers, in light of the fact that the FTC (or local equivalents) forces their hand with respect to disclosures related to the fact that most traders lose money.
To add to the statement in question, we want to point to a lesser known one: the fact that despite ultimately losing money, a lot of the traders in question were in profit at one point or another, yet didn’t realize any gains or pull the proverbial trigger, if you will.
Can you lose money as a trader or investor despite being “right” about the big picture move?
Can you lose money as a trader despite the fact that your positions are frequently in the green, as things are developing?
Once again, yes.
The key to understanding why the answer to both questions tends to be affirmative revolves around wrapping your head around the importance of realizing gains. Whether you are investing in Chinese assets, US stocks, European bonds, cryptocurrencies, Beanie Babies or anything else, the name of the game is understanding that until you have secured your profits, they are nothing more than numbers on a screen.
Worse yet, they tend to give investors a false sense of confidence.
The investor who bought the previously mentioned Chinese share and sees how profitable his decision has been might end up on the receiving end of such an ego boost that he goes all-in next time, well before realizing gains when it comes to his initial trade. Needless to say, this doesn’t always go well, on the contrary.
As a conclusion, we will limit ourselves to stating that there is far more to investing and trading than meets the eye and it is oftentimes the seemingly insignificant nuances which lead to investors losing money and in our case writing off Chinese assets as a destination for their capital completely, when a few simple additional decisions could have enabled them to do reasonably or even very well. A lot of times, wisdom in terms of trading and investing is merely a function of making a few small decisions properly when the time is right.