Paper gains are ‘naughty’

All that glitters is not gold. The adage holds water when it comes to investing. Many investors might feel elated when brokerage platform pops up green arrows and rising numbers. However, the dancing green indicators do not always transform into actual wealth, owing to two kinds of gains that often go hand in hand — realised and unrealised.

A realised gain is earned only when an asset is sold for a price over actual cost and profit is booked. In contrast, an unrealised gain represents a rise in value not yet converted into cash. Financial experts call unrealised gains notional profit; for brevity, we can call it ‘notiprofit’ (a portmanteau of ‘notional’ and ‘profit’). For example, Ms. Sudha bought 20 shares of Jumbo Ltd. at ₹500 each and sold them for ₹750 each. Here, the sale is executed and profit of ₹5,000 is realised and transferred to her bank account. Realised gains can be reinvested, spent or taxed.

Only on paper

Notiprofit is just a rise in the value of an asset you still hold. If Ms. Sudha believes the stock would rise further, she might continue to hold it without selling and this is notiprofit or paper gains, which can’t be reinvested or spent. Notiprofit might vanish in the blink of an eye in a highly volatile market. In short, profit is tangible and measurable; whereas notiprofit is intangible and exists only on paper.

Notiprofit can be seen across several segments of the financial ecosystem such as stocks, mutual funds, cryptocurrencies, Alternative Investment Funds (AIFs), private equity holdings, employee stock options and even collectibles or art, wherein everyday price movements create mirage-like surpluses in value.

In real estate, notiprofit appears more dramatically. A house purchased decades ago might have doubled or even tripled in market value. But unless it’s sold or monetised, the gain remains notional. In reality, for many reasons, the house might not be sold at all, making the profit merely a mirage.

The house owner may feel richer but his wealth is locked in the property and cant be easily converted into cash, real profit.

Factors such as liquidity, transaction costs and market cycles further influence when or whether notiprofit ever becomes real profit. Liquidity refers to how quickly an asset can be converted into cash. Highly-liquid assets such as stocks or mutual funds can be easily sold, allowing notiprofit to be realised quickly. Low liquidity (or illiquid) assets such as real estate, AIFs or private equity are harder to sell and so paper gains remain stuck longer, sometimes indefinitely.

Transaction costs such as stamp duty, registration fees, brokerage, taxes, reduce the eventual conversion of notiprofit into profit. Market cycles also play a vital role: waiting too long in the hope prices will rise further can devour notiprofit if market turns bearish whereas in a bull market, prudent action can transform notiprofit into real profit quickly.

It must be noted that the tax implications depend on whether a gain is realised or unrealised. In almost all cases, notiprofit is not taxed because no transaction has occurred.

Potential wealth rise

Notiprofit signals potential but not real wealth. From a behavioural perspective, a few investors might not book profit on time and stay content with just notiprofit, believing the gains will continue to grow. Their satisfaction is mostly tied to unrealised gains. Such patterns of decision-making highlight the mindset of what can be conveniently called ‘notivestors.’ Understanding the difference between profit and notiprofit helps investors judge their true financial position and avoid the pitfalls of overreacting to paper gains as ‘notivestors’ often do.

(The writer is an NISM & CRISIL-certified Wealth Manager and certified in NISM’s Research Analyst module)