Paper Profits in Investments

IT is always a source of satisfaction to the investor when reviewing his security holdings to line! that the market value of his stocks and bonds is greater than the amount he originally paid for them. Instinctively he feels that the market appreciation is evidence of his investment, foresight, of an improved safety factor in his holdings, or of newly found wealth within his grasp.

There is every reason why an investor should he happy in the knowledge that all has gone well with his investments. A rise in the price of a bond or share of stock is privia facie evidence that it is more favorably regarded by the market than it was when the investor bought it. Far better, indeed, that its value should go up, relieving him of all worry about its safety, than that it should go down. But how else is the investor better off? Is he justified in assuming that because he has a paper profit in his holdings he will have more money to spend?

The answer to this question, so far as the great majority of conservative investors are concerned, must be given in the negative. Yet it is worth while to note certain possibilities on the affirmative side. Assume that an ordinary investor wishes to use his paper profits to increase his income. There is only one course open to him, and it is by no means certain in its results, He must sell his securities, withdraw from the market, and wait for security prices to fall. During the period of waiting he can keep his funds on deposit in a savings bank at interest; he can buy notes and other short-term investments hav ing a maturity of three or six months; or he can buy bonds maturing in one, two, or three years,

anticipating as best he can the time when long-term bonds and investment stocks will again become attractive bargains.

If the investor succeeds eventually in buying back his securities at a lower price, his real profit on the transaction, after making allowance for the smaller income he received during the waiting period, will amount to something less than the difference between the price at which he sold his securities and the price at which he bought them back. He will have his original securities, or their equivalent, and an expendable profit in the form of cash. The cash profit may be greater or less than the original paper profit, all depending upon the price at which the securities were repurchased.

Operations of this kind may be very profitable at times for those who have a thorough grasp of the principles underlying the cycle of security prices. But such operations are highly speculative, and should make small appeal to the majority of conservative investors. There is always the danger, for example, that unforeseen circumstances will cause Security prices to remain high for an indefinite period, or will force them still higher, in which case one might not he able to buy back one’s securities without suffering a substantial loss on the transaction.

The conservative investor, as opposed to the speculator in securities, is one who is interested primarily in buying future income. He is not necessarily versed in the business of buying securities one day and selling them the next. He is essentially an accumulator of sound investments, He is on the lookout continually for bonds and investment storks which hold promise of yielding a dependable income — dependable during periods of business depression no less than in periods of business prosperity.

Now suppose a conservative investor should be tempted to make his paper prolits contribute something toward his income and spending ability by selling the securities in which he has a ‘ profit ’ and buying others to put in their place. He would soon discover that little or nothing could be gained on an exchange. He would find that other securities of the same grade had appreciated in value quite as much as those he already held, and that their income yield was no greater. Frustrated in this manoeuvre, he might try an alternative plan. He might exchange his highgrade investment holdings for bonds and shares of an inferior quality, in which the element of risk was obviously greater. His income would then be larger but less dependable. Would he be any better off after making a conversion of this kind? Would he have saved any of his paper profit? A moment’s reflection would show that the same conversion, if profitable, could have been made just as profitably before security prices rose and the paper profit emerged.

There are, of course, astute investors who know v alues so well that they can oftentimes increase their interest or dividend yield slightly by selling the investments in which they have a paper profit and immediately buying other equally high-grade securities which are selling below their investment worth. It should be observed, however, that only a modicum of paper profit can be saved through such transactions. It should be observed also that the number of investors who are capable of finding or recognizing investment bargains of this kind is extremely small.

It may safely be said that it is practically impossible for the ordinary investor to derive any permanent gain from a general rise in security prices if he stays in the market for incomepurposes. His paper profits are ephemeral. Whether he leaves them in his security holdings undisturbed or converts them into cash for reinvestment in other securities is a matter of no great consequence. Invested or reinvested, they are still paper profits waiting to be wiped out by paper losses when security prices fall.

Some investors have not given proper consideration to these principles. Seeing great ‘profits’ within their grasp as a result of the tremendous rise in security prices during the past eight years, they have sold their investments, converted paper profits into cash, and then spent the cash profits for the satisfaction of pent-up desires. What portion of their original capital remains will not buy as much income as it. formerly commanded. Apparently these investors did not realize that in spending paper profits they were spending a part of their capital.

Individual investors are not the only ones who have boon at fault in this respect. There are prominent institutions, organized for the holding of bonds and investment stocks, which regularly report as profit the capital gains arising from the sale of securities. Practices of this kind invariably make for good financial showing while security prices are rising, but they invariably cause trouble in time of falling prices.

The investor is always justified in rearranging his security holdings to fit his changing requirements — selling securities which have become too good for his needs, getting rid of others which have not proved their worth, and substituting in their place something that may he expected to produce a dependable income, more likely to grow in amount than to diminish. This is all a legitimate part of the business of sound investment. It is something vastly different from the popular pastime of trying to convert paper profits, the guardian of one’s capital, into spending power.

GEORGE E. PUTNAM