You dont actually make or lose money until you sell your investments.

Motley

The stock market can be volatile, and the value of an investment can go up or down at any time based on news, current events, and overall market conditions. And stocks arent the only asset that can gain or lose value; other investments, like bonds and mutual funds, can also rise and fall depending on a number of factors.

If youre an investor, it can be nerve-wracking to watch your portfolios value drop -- and thrilling to watch it soar. But the important thing to remember is that you dont actually make or lose money until you sell your investments. When you sell an asset, your gain or loss becomes realized, and you either make or lose money on your original investment. By contrast, unrealized gains and losses only exist on paper; theyre not real yet, because you havent made a transaction.

This is an important distinction not only for the reasons above, but also because realized gains and losses, unlike unrealized gains and losses, can affect your taxes owed -- for better or worse.

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Realized versus unrealized gains

When the value of an investment exceeds the price you paid for it, thats considered a gain. Whether or not you actually profit from that gain is a different story. Lets say you buy 100 shares of Company Xs stock at $10 a share, and months later, the price jumps to $15 a share. If you were to sell those shares, youd stand to make a $500 profit. But if you didnt actually sell those shares, you wouldnt make any money. Thats the difference between a realized and an unrealized gain.

A realized gain is the profit from an investment thats actually been sold, as calculated by the difference between an investments purchase price and sale price. An unrealized gain, by contrast, is simply a gain on paper. Realized gains are taxable, so if you sell an investment at a profit, youll need to report that income and pay capital gains taxes. On the other hand, if the value of one of your investments goes up but you dont actually sell it, it wont impact your taxes.

Realized versus unrealized losses

When the value of an investment drops below the price you paid for it, thats considered a loss, but whether or not you actually lose money depends on what you do with the investment in question. Lets say you buy 100 shares of Company Ys stock at $10 a share, and a few weeks later, the price drops to $5 a share. If you were to sell off those shares, youd lose $500. But if you sat tight and did nothing, you may not lose a cent.

Just like gains, losses are unrealized until investments are liquidated. If youre sitting on an investment that has lost value and you dont need to sell it immediately, then you may be better off waiting to see if its value climbs back up.

On the other hand, sometimes your best option is to sell a losing investment in order to cut your losses and lower your taxes owed. Capital losses can be used to offset capital gains for tax purposes. If you realize $1,500 in capital gains in a given tax year, and you also realize a $1,000 capital loss, then youll only owe taxes on $500 in gains. Furthermore, if your realized losses exceed your realized gains for a given tax year, then you can deduct up to $3,000 of the remaining losses from your taxable income. And if your net losses exceed that $3,000 threshold, then you can carry the remainder forward to future years.

Keeping tabs on your portfolios performance can help you make smart decisions when it comes to selling investments and paying taxes. Try not to panic the next time you see your investments decline in value. An unrealized loss might weigh on your mind, but you wont actually lose money until you make a move. 

This article is part of The Motley Fools Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. Wed love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!

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