Did my investments do well? Many investors look at the unrealized gain/loss on their brokerage statements and believe this is an indication of the return on their investment. The truth, however, is a bit more nuanced.
In this Insight, I explain why unrealized gain (or loss) does not necessarily equate to investment performance, explore how this metric is calculated, and suggest how Investors can better understand their investments’ growth over time.
An unrealized gain or loss shows the market value of an investment, less the cost basis of that investment. These changes in value are sometimes referred to as “paper” gains and losses because they are not “realized” until you sell the underlying asset.
It’s exciting to watch market appreciation grow over time. However, it’s important to understand this metric doesn’t necessarily tell the whole story of what an investment has earned. To understand why, it’s helpful to take a moment to understand what the “cost basis” of an investment truly means.
To take a step back, cost basis is the original price paid for an investment plus reinvested distributions. This includes dividends and capital gain distributions.
Reinvested distributions are added to your cost basis because you pay taxes on those distributions annually when your tax return is filed. In contrast, you only pay taxes on market appreciation when an investment is sold.
Let’s say you invest $10,000 in mutual fund A and $10,000 in mutual fund B. This $10,000 represents the original cost basis for each mutual fund.
Over the course of the year, the market value of mutual fund A goes up by $1,000 due to market appreciation, but there are no dividends paid. Mutual fund B earns $1,000 of dividends that were reinvested, but there is no market gain.
What does this mean?
Both mutual fund A and Mutual fund B have a new market value of $11,000, and a total return of 10%.
| Original Purchase Price | Market Appreciation | Dividends Reinvested | New Market Value | Total Return | |
|---|---|---|---|---|---|
| Mutual Fund A | $10,000 | $1,000 | 0 | $11,000 | 10% |
| Mutual Fund B | $10,000 | $0 | $1,000 | $11,000 | 10% |
But, though the market value and total return are the same, the unrealized gain/loss for the two positions are different.
| New Market Value | Cost Basis | Unrealized Gain/Loss | Total Return | |
|---|---|---|---|---|
| Mutual Fund A | $11,000 | $10,000 | $1,000 | 10% |
| Mutual Fund B | $11,000 | $11,000 | $0 | 10% |
The unrealized gain/loss is only an indicator of an investment’s embedded taxable gain and does not reflect an investment’s total return. This can make performance difficult to track over time.
While unrealized gains can offer a helpful snapshot of growth for tax purposes, they don’t tell the full story. For a clearer view of performance over time, investors are better served by tracking total return, which incorporates both price appreciation and any income generated from dividends or interest. For a deeper explanation, see our Insight on Total Return: Understanding Investment Performance Fundamentals.
In the case of a realized loss, tax loss harvesting may provide a valuable strategy for making the most of this opportunity to reduce your long-term tax liabilities. This strategy is a great example of why tracking unrealized gains and losses is an important part of portfolio management.
Working with a financial advisor is often the best way to understand your portfolio’s long-term performance—and how to optimize it in alignment with your personal financial goals.
At Wealthstream, we employ specialized software for performance reporting, a tool that allows us to process complex performance calculations in order to focus on the metrics that really matter for your future. Wealthstream clients can view their performance uploaded quarterly to the Vault on myWealthstream, or by requesting performance reports from their advisors.
If you’re interested in evaluating your long-term investment approach, our team is here to help. We invite you to schedule a conversation with an Advisor.