This week, Gail addresses what to do with losing investments and how December is the best month to get out if you can.

Dear Gail,
I have a large sum invested in an aggressive mutual fund. Over the past year I've lost about half of my initial investment. I'm really torn as to what to do at this point. Sell and take a beating, or hold and hope for a prominent upturn.

— Mike

Dear Mike,
Don't feel like the Lone Ranger! You're not alone in owning investments which are "under water." The good news is that there is still time to squeeze some lemonade out of this "lemon" provided you act quickly. There is even a way you can sell this investment and still protect yourself if the market takes off.

December is typically when people sell losing investments in order to generate a tax deduction. The question is, why December? Why not May? Or September? Or any other month?

Personally, I think it's because we hate to accept the fact that an investment has not turned out as we had hoped.

A growing body of research in the relatively young field of Behavioral Finance is uncovering some pretty interesting insights about how we make decisions about money. In a nutshell, it comes down to this: by virtue of the fact that we are human, we often make irrational choices when it comes to our finances. Recognizing a loss is a great example of this.

Various studies have shown that losses make us twice as upset as the satisfaction that's generated by a gain of equal magnitude. In other words, you feel twice as bad about losing $100 than the pleasure you felt over winning $100.

We've all experienced this, whether it's at a casino or the weekly church bingo game. If you're up by $50, you might feel pretty good. But if you're down by that amount, you're REALLY mad! We beat ourselves up over our losses.

In fact, Behavioral Finance has found in study after study that we hate losses so much that we will go to extremes to avoid them. Anyone who has stopped opening their quarterly statement knows what I mean. We just don't want to face the fact that our investments are down.

Being reluctant to sell a losing investment is another way this denial manifests itself. We tell ourselves, "If I haven't sold it, I haven't lost anything."

This is all the more irrational because there is actually an economic advantage to selling an investment which has lost value: the tax deduction we can take. Yet, despite this, most of us are still reluctant to throw in the towel and sell. Instead, we concoct all kinds of elaborate rationales for holding onto it.

Some people make a deal with The Market God and promise "If I can just break even, I'll get out." Others, like you, Mike, rationalize staying in a losing investment because you might miss a rebound.

So how should you handle a loss?

First, recognize that every investor — including Warren Buffett and Peter Lynch — has bought things which have subsequently gone down in value. What separates the novices from the pros (and the millionaires) is the ability to get over the emotional reaction we have to a loss and move on.

So here's my suggestion: Take a good, hard look at every loss in your portfolio and ask yourself why that particular security is down. In your case, Mike, the growth sector of the stock market — and aggressive growth stocks in particular — have been out of favor since March 2000. It's unreasonable to expect your particular mutual fund to do well if the entire sector of the market it's in is doing poorly. But if it's doing a lot worse than similar investments, that should cause you to take a closer look.

On the other hand, if you own a value-oriented mutual fund and it is worth considerably less than you invested in it, you need to investigate further. Value stocks have fared much better than growth stocks in the past few years, so a substantial loss in this type of fund should raise an eyebrow.

If there's no red flag — that is, if your investment is behaving like others in its industry or sector — and nothing has fundamentally changed, ask yourself why you bought it to begin with. Did you decide you needed exposure to this sector of the market in order for your portfolio to be properly diversified? Do you still believe the company or the mutual fund is run by experienced, capable professionals? Do you think the market will eventually turn around and reward you for your patience? Then you might want to stick to your guns.

The ultimate question you should ask yourself is this: "Where can I best re-coup my loss — by sticking with this investment, or by cashing it out and re-investing the proceeds elsewhere?" If the answer is "elsewhere," you should bite the bullet and sell.

On the other hand, if, after a thorough evaluation of the situation, you honestly think you can get back to break-even level and on to profitability by holding this investment, then consider adding to your position. Huh ?

That's right. If you really have conviction that this is a solid investment, ante up. This is the time to "buy low." It's how Warren Buffett got to be the most successful investor of our lifetimes.

If, on the other hand, you've finally decided to sell, there is a way you can have your cake and eat it, too.

In order to take a loss on an investment, you cannot violate the "Wash Sale" rule. This says if you sell an investment at a loss and replace it by buying "substantially identical" securities either 30 days before or after the sale date, you lose the ability to deduct the loss.

For example, say you own 100 shares of XYZ common stock that you bought two years ago for $50 a share. It's currently selling for $20 a share. On the one hand, you could really use a tax deduction. On the other, you think XYZ is a great company and don't want to miss out if the rest of the world finally recognizes this and the stock takes off. What do you do?

Well, what you can NOT do is buy XYZ common stock on, say Nov. 15th at $20 a share and then sell your older shares two weeks later assuming you'll get to write off the loss. Because you bought the same security within 30 days of the sale, the loss is not deductible. The same would be true if you sold your shares on Dec. 20th and bought XYZ again the first week in January.

However, what if you bought something that was similar to XYZ stock, but not "substantially identical"? For instance, if XYZ offered convertible bonds, you could invest in these without violating the wash sale rule.

In your case, Mike, if you want to maintain your exposure to the aggressive growth sector of the market, you could sell the mutual fund you're currently in and invest the proceeds in another aggressive growth fund managed by either the same company or a different one. And you can do this on the same day .

This is known as a "Tax Swap." There's no 30-day waiting period because although you're buying a similar security, it is not considered "substantially identical." So you get to take your loss and still be in a position to benefit if this sector of the market rebounds. Any time you are considering such a move, it is best to consult your financial advisor to make certain that the securities are, in fact, sufficiently different to be considered exempt from the rule.

It's also possible to generate a "double-dip" deduction. You simply sell your investment at a loss and donate the proceeds to a charity. This gives you both a tax-deductible loss and a tax-deductible charitable donation!

Hope this helps,
Gail

 

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.