Paper Profit and Paper Loss Explained: Definition and Mechanism
Paper profit or loss refers to the unrealized capital gain or loss on an investment, representing the gap between the original purchase price and the current market value.
Gordon Scott has over two decades of experience as an investor and technical analyst. He holds the Chartered Market Technician (CMT) designation.
What Does Paper Profit (or Paper Loss) Mean?
A paper profit or loss represents an unrealized capital gain or loss on an investment. For a long position, it is the difference between the current market price and the purchase price.
In the case of a short position, it is the difference between the price at which the asset was sold short and its current price. These gains or losses remain on paper until the investment is closed, at which point they become realized and translate into actual monetary profit or loss.
Key Points to Remember
Paper profits and losses reflect temporary changes in investment value.
Also called unrealized gains or losses, these fluctuate while investment positions remain open.
They are important for accounting and tax reporting purposes.
Delving Deeper into Paper Profits and Losses
Paper profits and losses are synonymous with unrealized gains and losses. They exist only as entries in an investor’s or entity’s financial records until the positions are liquidated and converted into real cash. Sometimes, these figures are influenced by accounting methods such as mark-to-market (MTM) valuation, which affect portfolio valuations, mutual fund NAVs, and tax calculations.
Investors often retain paper profits, anticipating further appreciation of the asset’s value. Additionally, they may delay realizing gains to defer tax liabilities or convert short-term gains into long-term gains for favorable tax treatment.
Conversely, investors might hold onto paper losses with the hope of a market rebound to recover their losses, while also considering the tax implications before deciding to realize those losses.
Distinguishing Between Paper and Realized Profits
It’s common for investors to rationalize poor investment choices based on paper gains or losses. Consider these scenarios:
- Investors often believe they haven’t lost money on a declining asset as long as they haven’t sold it. However, a 25% unrealized loss means a 33.3% gain is needed just to break even, and mounting paper losses reduce the likelihood of recovery.
- During the dot-com era, many "paper millionaires" emerged through employee stock options that couldn’t be sold immediately, leading to financial ruin after the market crash.
- When investors see a stock rise sharply, they may become overconfident and ignore warning signs, holding on too long as prices fall and their paper profits vanish, missing the opportunity to secure gains.
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