Yahoo Finance The 4 Different Kinds Of Financial Losses (And Why They Matter)
People, in general, don’t like to lose. As a society, we applaud winners and put down losers. After all, our species depends on the survival of the fittest. Loss aversion is hardwired into our brains. We perceive the pain of losing twice as strongly as compared to the joy of gaining.
With the financial markets roiled by recent turbulence, some of us may be suffering from some form of financial loss and the psychological pain that comes with it.
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#1 Loss Of “House Money”
In casinos, house money refers to when a gambler takes winnings from previous bets and uses some or all of them in subsequent bets. This term is borrowed over to the investment world to coin the term: house money effect.
The house money effect suggests that people tend to buy higher-risk stocks or other assets after profitable trades. However, with greater risk, comes the potential for greater gains and losses as well.
For example, we invested $500 in bitcoin before 2020 and we profited 400% when we sold it sometime in 2021. Taking our profit of $2,000, we decide to invest in other crypto investments such as Luna and TerraUSD to earn yields as high as 20% p.a. We then reinvested our returns and eventually grew our crypto portfolio to $20,000. However, the Luna de-peg happened and suddenly our portfolio crashed to $200. We have suddenly lost our house money of $20,000.
Thankfully, we haven’t technically lost any real capital because we had recouped our initial investment capital of $500. However, we may have lost out on the opportunity cost of deploying that $500 to other purposes or investments.
The loss of “house money” while painful, isn’t as debilitating as other forms of financial losses. However, it is a reminder of the importance of protecting our capital and the foolery of taking on too much risk.
Pain level: Grief of dreams and could-have-beens
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#2 Capital Loss
Capital loss is more damaging to our finances compared to “house money” loss because we are losing not just our potential profits but also the hard-earned capital.
For most of us, the initial sum of money (the capital) we use for investing is earned with blood, sweat and tears from salary or savings. We incur capital loss when we sell our investment for less than the original purchase price.
Taking the same example, if we had invested $20,000 in capital into the same crypto portfolio, instead of growing it from “house money”, it is likely that we would feel the same pain of the potential profit loss on top of the pain of losing the money earned though hours of work or years of savings.
Sometimes the loss of “house money” also incurs capital loss if we had continued to invest our capital along with our profits.
Regardless, capital loss is often damaging to our finances as these funds are often the basis of our financial planning. Whether we are saving up for a housing downpayment, our child’s education or our future retirement, having that lump sum wiped out would take time to recover from.
Pain level: Grief over loss of funds and the time, blood, sweat and tears to build up those funds. And the opportunity cost of rebuilding these funds
#3 Unrealised Loss Or Paper Loss
However, capital loss is different from unrealised loss or paper loss. Capital loss is only incurred when we sell. If we continue to hold the investment, it is technically an unrealised loss or paper loss because we have not yet sold and realised the loss.
Just because the loss isn’t realised doesn’t mean that it will recover in value. Sometimes, it may be better to realise the loss than to let the paper loss continue.
For example, in the initial stages of Luna de-peg, some investors sold and realised their losses (some may even incur capital loss, not just a loss of “house money”). However, some investors may have continued to hold on to Luna because they believed that it is a temporary paper loss and Luna’s value would recover, which did not happen.
Sometimes, the choice of realising the losses is not up to us as individual investors. For equities, a paper loss may be realised when the company declares bankruptcy or delists. Some corporate actions will force shareholders to realise their investment gains or losses.
Pain level: Roller coaster of emotions, sleeplessness and anxiety as the paper losses change
Read Also: Are Paper Losses “Real” Losses? And What Should Investors Do When Their Investments Fall In Value
#4 Leveraged Loss
Unrealised losses can also be realised due to margin calls. This can happen when there is a sharp decline in value (paper loss) in a margin account. To maintain the minimum value in the margin account, the brokerage will require the investor to deposit additional funds. If the investor is unable to deposit more funds, the broker may close the existing account holdings to meet the minimum value requirements. When a margin call happens, the paper losses may be realised to actual losses. Not only are these losses capital losses, but they are also leveraged losses.
In a margin account, investors use margin financing or leverage to trade and invest in more shares to earn higher returns. Because of the leverage, the risks and returns are amplified.
For leveraged loss, you not only lose your potential profits and/or capital, but you also incur debt along with loss.
For example, we have a margin account with 5x leverage. We buy $10,000 of Tesla using $2,000 of our own money and we borrow the other $8,000 from the broker. Tesla’s share price then fell from $1,200 to $700, leaving us with a loss of $4,166. If we sell and realise the loss (possibly because of a margin call), we will obtain $5,384 which means we still owe the broker $2,616 ($8,000 – $5,384). We have not only lost our capital of $2,000 but we also incur a debt of $2,616.
The danger of using leverage is that it not only amplifies our gains but also our losses. Any drop in value is magnified when leverage is used, and this also makes investors more likely to make trading or investment mistakes such as panic selling.
Pain level: Multiplied by the amount of leverage used
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