Beyond The Headlines
Phantom Losses & Neighbors Getting Rich
What are “phantom losses?” — In investing, we have gains and losses, but how many types of both are there? Last summer, I wrote a short article about two types of gains. Some recent conversations with clients, colleagues, and fellow investors made me realize that there are more than two types of losses. There are realized losses, unrealized losses, and apparently also “phantom losses.” I like to learn new things, and this was definitely a bit of a discovery. I felt compelled to share it with you, so here it is!
I don’t think you’ll find the term phantom losses in any investment manual, not in this context at least. It’s the best label I could find for this third category. Let’s start from the beginning, though, and examine the two more obvious, yet still at times, confusing types of losses: realized and unrealized losses.
Every stock we buy, we buy with an intention to make money. If we ever sell it, we’d like it to happen at a higher price than we paid. The world is too complex, the future too uncertain, and the information we can gather too imperfect to make every single investment a success. We know it, we accept it, and we prepare for it. The best we can do is minimize our losses, which helps us maximize our net gains. At all cost, we attempt to avoid a permanent loss when a particular holding turns out to be worth nothing. We call it avoiding zeros. In recent history, we have managed to avoid this unpleasant experience. We want to keep it that way.
What happens, though, when we make an investment, and the investment case doesn’t hold anymore. Enough might have changed in the meantime that we see low odds of the business regaining its footing and our purchase turning out to be profitable. In this situation, we decide to sell the position and realize a loss. It’s usually better to act quickly before too many fellow investors embrace the new, less attractive reality.
This is the kind of loss that we call a realized loss. The stock gets sold, and we move on. There might be some tax benefit of such a loss for the client, but that’s as much we can gain from it at this point, apart from a potential lesson for the future.
After we buy a stock, it may happen that the price drifts lower, and we are looking at unrealized or paper losses. We are waiting for a recovery, and the investment case is still valid. We don’t worry about a paper loss. We tend to look for companies whose stocks are down, cheap, and out of favor. Their prices might still be dropping for a while before we see any improvement. If anything, this offers an additional buying opportunity. That’s the very reason why we buy slowly and build the position over time. An exception to this approach would be last year’s March sell-off when we had a brief but very attractive buying window, and we had to act fast.
The first two types of losses are a part of our investment process, not all stocks will perform as expected, and we may have to sell them, or it could take our holdings a while to perform, and we may need to tolerate those paper losses for a bit.
Phantom losses are a category of their own. I think I was always aware of their existence, but I never paid too much attention to them, and I don’t expect it to change in the future. Either way, I believe it might be a good time to discuss them in more detail. With the stock market hovering close to all-time highs, there are possibly very few unrealized losses in the portfolios. The focus moves to everything that’s not in the portfolio. In times like this, market enthusiasts can be full of regrets. That’s the fear of missing out (FOMO) territory: “If only I bought this stock five years ago or even a month ago, then I would have had this much more today.”
There are many stocks and other investments that we never bought and never considered buying, but their prices rose. They might feel like a missed opportunity to some. These could also be stocks we considered and chose not to buy, but their prices rose, and finally stocks we decided to sell, but their prices rose even more.
The world of FOMO is big and has no limits. There is no better fuel for it than watching others get rich. J.P. Morgan, the legendary 19th Century Gilded Age banker, once said: “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.”
As much as we are aware of phantom losses, they are outside of our immediate attention. There are thousands of stocks out there, there will always be many that go up for various reasons, but we would never feel comfortable holding them.
We continuously review our investment cases for stocks we bought, we hold, we sold, and we passed on, it helps us sharpen our approach, but we don’t waste much attention or energy on the opportunities we “missed out” on.
We keep it simple. We are happy as long as we can accomplish our investment goal within our chosen investable universe. Our goal is to keep and grow over the long run the family fortunes we manage. There is a lot we can do though to minimize even the phantom losses though. Our investable universe is not set in stone, and we have owned many companies that initially were outside of our original stock universe.
What’s more, we prefer to act gradually, both buying and selling stocks, but especially selling. This particular policy allows us to avoid leaving too much money on the table if a stock we own continues to rise beyond our expectations. We call this approach being a value buyer but a growth holder. We do our best to buy them right, but then we let the winners run.
Bottom-line: we focus on two types of gains, and losses, realized and unrealized. As much as we’d like to have all gains and no losses, that’s not the investment reality. We do our best to maximize the gains and minimize the losses. We know that regrets and the fear of missing out are a dangerous combination in investing and can make us blindly accept much higher risks for elusive rewards. Let’s remember, though, that phantom losses are just that — phantom, and watching our neighbors get rich might get in the way of our financial judgment.
Happy Investing!
Bogumil Baranowski
Published: 4/22/2021
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The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.
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