In all of the recent talk about the market declines, an interesting question came up concerning what you lose when your portfolio goes down in value. It’s a great question, with a really simple but important answer.
You have the same amount of shares that you did previously. They are just worth less at the moment. So say you bought 10 shares of Mutual Fund A at $20 a share. You invested $200. Now let’s say that the value of Mutual Fund A rises to $30 a share. Your investment is now worth $300. If it subsequently plummets to $10 a share, you only have an investment worth $100.
The key thing to remember is that these values are theoretical until you sell Mutual Fund A. You will always have 10 shares. The price/share (determined mostly by supply and demand) at the time of sale determines how much you’ve gained or lost on the investment.
This fact is what makes selling in a down market so dangerous. In a time of steep decline, people get nervous and sell their riskier equity investments in exchange for safer investments like bonds or money market accounts. As such, they lock in their losses because they have not given an investment the chance to regain or increase its value.
Granted, they could be preventing a further loss if they invest in a stock or mutual fund that won’t ever recover (part of the danger of investing in individual stocks). But if you have a well-diversified portfolio and a long time horizon, your investments will have many ups and downs, and you will buy more and more shares at different prices.
Odds are you’ll never be able to time the market perfectly where you always buy low and sell high. One goal should be to lower your average share price and spread your investment risk of a long period of time by contributing a fixed amount on a regular basis (dollar-cost averaging).