Paper Profits and Paper Losses

IN current use among capitalists and those who serve them are numerous words and phrases to which, though they appear to satisfy, no generally accepted meaning attaches. Investing as yet has not developed standard threads, gauges, or calibrations. The best definition even of investing is still that which each individual capitalist propounds for himself and the world. As for the meaning of such terms as ‘safe,’‘conservative,’ ‘semi-speculative,’ ’business man’s risk,”trustee’s investment,’ ‘first mortgage,’‘preferred,’ and so forth, the investor simply pays his money and takes his choice.

In view of the great increase in market values of bonds and stocks over the past few years, one obiter dictum familiar to financial circles particularly deserves analysis at this time. This dictum reads: ‘You wi11 never go broke taking profits.’ Proverbs, fortunately or unfortunately, have a habit of being flatly contradicted by other proverbs, and this saying — it is hardly a proverb — has its contradiction. Brokers sometimes advise, ‘Take your losses and let your profits run.’ A problem confronts us.

Profit and loss are terms for designating the character and the amount of difference between two values. But what two values? Over what period of time? Under what conditions? Life insurance companies on their bond holdings report five different values: cost, book, par, amortized, and market. In defining profit and loss they have great latitude. They use it. The private investor usually recognizes only two values — cost and market. But he too has plenty of room for individuality. He may refer to his aggregate profit on a security since he has owned it, or during the last year, or on the last complete transaction. He may forget the security and refer to the profit on a certain amount of capital over a certain period of time. The difference between cost and market value on securities he now owns he refers to as a ‘paper’ loss, or a ‘paper’ profit. In actual practice he sees a great difference between a real and a ‘paper’ loss or gain, whereas this difference amounts to almost nothing. But it is not the incomparability or the variation in meaning of profit-andloss figures which causes the investor any serious trouble. It his use of these figures for a wrong purpose, his attributing to them in the solution of an important problem a weight they do not deserve.

Give any investor a sound reason for selling his National Roads common, and ninety-nine chances out of a hundred his first thought will be to find out what it cost him. If he is seriously to consider selling, far better would it be in most cases if he could forget absolutely what his securities cost. But he cannot. If present market value is below his cost, he immediately differentiates between what he considers merely a paper loss which may become a profit if the stock is held and an actual permanent loss if the stock is sold. Then, choosing what he considers the lesser of the evils, he holds his stock.

But his conclusion is not justified on any such reasoning, for the paper loss may prove permanent and the real only temporary. He has followed the wrong trail. He has viewed the result, which he regards as evil, and which he refuses to acknowledge, instead of considering the stock which produced the result.

If the present market value of National Roads is above our investor’s cost, he considers his problem greatly simplified, unless the profit is so large as to be complicated by a prospective loss through taxes, and unless he has held National Roads long enough to have a sentimental attachment for it. But if the profit is small, he usually can be persuaded with little difficulty to convert it from ‘paper’ to pocket. If losses are evil, profits are good. But his reasoning in this case is no more justified than before.

The careful investor buys a bond or a stock because he believes it is sound and attractive. He owns his bond or stock because he believes it is sound and attractive. Not was sound and attractive when he bought it — is sound and attractive now, to-day, and every day he holds it. Whether or not it should be sold to-day is a question, therefore, that depends solely on the individual security’s present merits. What it may have cost on one nonsignificant day in the past when the present owner happened to acquire it has practically nothing to do with its worth to-day. But the present relative merits of other sound securities do have a bearing on its worth to-day.

The investor turning over in his mind whether to hold or to sell a stock, the market value of which is below the price he paid, should ask himself just one question: ‘If instead of this security I owned its present market value in cash, would I invest in another security or reinvest in this?' Or, stated differently, ‘Can I recover my loss more quickly and surely by continuing to hold this security or by exchanging it for another?' The feat is to regard the present amount of capital represented by the security rather than the past gain or loss it has produced.

The problem of the investor with a large profit in his security is more complicated. He must decide not only whether another security — equally sound, let us assume—is more attractive, but he must estimate how much more attractive. Specifically, he must determine his prospective tax (maximum to-day one eighth of his profit) and then decide whether another security within a reasonable time is likely to appreciate enough more than his own to pay the tax and more; whether such other security in case of market recession is likely to depreciate enough less than his own to save the tax and more; and finally, whether the insurance afforded by possible increased diversification is not well worth the tax premium required.

Though meaning many things to many investors, gains and losses should not occasion serious difficulty to the investor with proper perspective. It may be of help to remind ourselves that unsound securities as a rule are those which depreciate in value and show losses, that sound securities as a rule are those which appreciate in value and show profits, and that investors as a rule should own sound securities.

Therefore, if a proverb can be helpful, let it be ‘Take your losses and let your profits run.’

Sound investment principles supplemented by adequate records and standards for measuring resulls are greatly needed by most investors. When authorities do not agree on principles, records are all the more important. The careful investor should see a quarterly balance sheet and income statement of his investment enterprise just as of his commercial or industrial enterprise. He should seek not merely to do well, but to know how well he is doing, whether he might not do better, and how. He should compare his policies and results with those of other investors. Adequate records give a definite meaning to ‘profit ’ and ‘loss’ and enable the investor to weigh facts instead of feelings.