On Capital Gains & Losses Part III

Today we'll clear the air on a few questions that I've been asked from our first two posts on capital gains & losses. I also want to point out a few things as well.

1. Last week's post could be interpreted as an attack on longer term or what is often called "Buy & Hold" investing. I don't want to take sides on its merits or whether long term investing still works. That is a subject for gurus, economists or perhaps another series of posts. It is currently a controversial area of debate and is beyond the ken of this current investment thread.

But I would note that most individual investors are in some way "Buy and Holders". For example many people have long term holdings in individual stocks at the company they have worked for. When companies are young and growing this is a wonderful way to accumulate assets. I have many clients who because they worked at one point for General Electric are long term holders of GE's common stock. Even if you don't own individual stocks you are likely averaging into mutual funds at work through your 401(k). Since this is statistically the case then we need to incorporate this thinking into our series on gains and losses.

My take on equities as it relates to "buy & hold" is that individuals need long term exposure to equities in general because they have historically provided superior returns to most other asset classes. However, with today's emergence of alternatives such as ETFs and even options , I don't believe individuals need the event risk of common stocks except in certain special situations. When it comes to "buy and hold", I prefer Jim Cramer of CNBC's definition which is "Buy and Homework". As we pointed out last week because this is how most individuals have traditionally invested then most long term investors are currently dealing with capital losses.

2. Individual investors as we have pointed out often have a hard time dealing with losses. So do money managers for that matter because we are human as well. However, anybody who invests money in the stock market will at some point be confronted with losing positions. It is part of the game. If you cannot deal with that then don't invest in equities. Professional traders will tell you that they lose money on almost half of their positions. Their difference is that their constant movement of money means that they will take these losses much more quickly than longer term investors are apt to do. I'm not suggesting that individuals all become day traders. I am suggesting that professionals understand that losses are part of the game and are part of what they must endure as part of the price of getting paid over time.

3. Investors also almost never see price movement from the market's point of view. Markets don't care whether your portfolio is making or losing money. Like "Ole Man River" markets just keep rolling along. Markets represent the collective decisions of millions of different participants with millions of different reasons for buying and selling. As such markets look out longer term and also take the shortest time frames into account. Markets don't care that humans break their investment time horizons down into units of measurement such as days, months and years. Markets exist to transfer risk and reward. Investments are rewarded by injections of liquidity (i.e. more buyers than sellers) and are punished by that same liquidity being taken away (more sellers than buyers). So markets don't care about capital gains or losses. But if they did and could talk they might do so through the following illustration:

Suppose you buy a stock at $10 per share. It moves up to 11.11 and then trades down to 10 whereby you sell it. From the investors perspective it's a wash- bought at $10.00 sold at same-nothing ventured nothing gained {forget the issue of commissions let's say they are 0 for this illustration}. Except from the market's point of view that's a 10% loss. That's right! From the market's perspective its the same as if you'd bought a stock at 10 and sold it at 9. Even so the market doesn't care if it's a gain or loss. Markets are forward looking mechanisms designed to assign a present value to a future event such as earnings. Because stocks are constantly looking ahead we need to do that as well. First though we need to deal with the emotional aspects of investing.

{Next week: Dealing with anger over losses.}

*Long General Electric in certain legacy accounts.