On Capital Gains & Losses Part V.1

I think as we cover investment losses we should begin by discussing the three principle reasons investors lose money. We're covering stocks in this series but this also applies to other investments. The three reasons are: 1. Bad investment timing. 2. An investment thesis that turns out to be wrong. 3. A sudden shock to the investment system that sends prices rapidly lower-i.e a crash. Today we'll discuss the first of these.

First I'm going to digress by discussing losses when using ETFs. I believe that ETFs simplify the investment process by giving investors exposure to equities as a class while removing the issue of single stock risk. That is I believe they remove from the investment process the issue of a security suffering a catastrophic investment loss due to an underlying fundamental problem with the investment. I define catastrophic loss as an investment which loses greater than 70% of its value with no visible way in a rational investor's time frame of ever recovering from that loss. I am also talking about when an investment goes away i.e. a General Motors going bankrupt. I am not talking about a market crash, we'll cover that in a few days. Rather I am talking about the possibility that a company through business or execution risk suffers irreparable harm to its stock price.

Now ETFs are not riskless investments! For example they are subject to the movement of whatever index they track. They are also subject to tracking errors- that is they can deviate from the price of the underlying index. Finally as ETFs become more popular they could be subject to certain types of execution risk. By this I mean nobody knows what will happen when they become so popular that more investors want to own these as investments than the underlying stocks in the index. We also don't know what could happen if on some particular dark investment day these vehicles cease to function as we currently understand them.*

However ETFs do take away single stock risk. Let's put it this way. So far nobody is out there talking about how their portfolios are worthless by being invested in the S&P 500 Spyder {SPY}. There are legions of folks who have gone down with Enron, General Motors, Lehman Brothers & AIG. There are just as many folks sitting on portfolios of stocks that are likely never to see their most recent highs of last year. Many banks are on this list as are companies like Eastman Kodak and possibly even General Electric.**

ETFs may take away single stock risk but they don't take away the risk that investors buy a security at the wrong time or the wrong price. To see how the masses are confronted with this problem go back and look at our chart from Part II of this series {See here: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-ii.html } There's plenty of people who simply bought the market at the wrong time over the past 10 years.

So what do you do if you've bought an investment at the wrong price at the wrong time? You must first evaluate whether you want to continue owning it in the first place and if you do then you must find opportunities to average down your cost basis.

Again this is easier with ETFs because with these you are simply trying to find price levels where you believe that valuation is attractive for your time horizon. Here then you are looking to add to these positions at the appropriate times. This is similar to dollar cost averaging with mutual funds. You must also take the opportunity when it affords itself of taking losses. I say this even if it means taking those losses in IRAs or 401Ks. Why do this?

First in taxable accounts it affords investors the opportunity to accumulate losses that currently have certain tax advantages. While these tax advantages are subject to change at governmental change at some future date, there is no current indication as of this writing of any intent to do so. To review the basics of these, go back and look at part I of our series. Link: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-i.html.

Second it removes the shock of seeing those losses every day for what right now could be years. Psychologically it is often hard for investors to stare at capital losses for long periods of time. Losses have already occurred in a portfolio when this happens. They have simply not been recognized. This can freeze the investment process. People often say "I can't do anything with this money until I get close to break even!". This can blind them to other opportunities or keep them in low growth investments for years at a time. All investors will be wrong at some point. It is often to difficult admitting that and moving on. Taking these losses helps free up not only dormant assets in the portfolio, it also helps free up the mind.

*We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.

** Long General Electric in legacy client accounts. Long SPY and related S&P 500 index ETFs for client accounts. Long shares in certain banks and certain financial services ETFs for client accounts.

{Tomorrow we will cover when an investment thesis that turns out to be wrong.}