On Capital Gains & Losses Part V.2

Today & tomorrow we'll finish covering the other two reasons that lead to capital losses. Yesterday we discussed bad investment timing. Today we will discuss what to do when you get the investment thesis wrong. Tomorrow we'll discuss the most timely issue which is how to deal with a market crash. We'll finish this up in the next two weeks on how to tactically handle losses in portfolios. We'll discuss what we believe are proper tactics for taxable and nontaxable accounts.

Wrong Investment Thesis: This is the easiest of the three issues that lead to portfolio losses to cover. You should almost never buy an investment without developing a reason for putting money into it. Even the best will get a thesis wrong, that's simply part of the territory. When the thesis turns out to be wrong you need to sell! You sell irrespective of gains or losses because what you believe is turning out to be wrong or has turned out wrong! It is often hard for investors to admit they are wrong but it happens all the time. This isn't limited to stock investing. Certainly investors who bet big three years ago on a continued housing boom have been wrong. The New York Times has lost almost all of its investment , something like a billion dollars, in the Boston Globe in the same manner.

Equity investors usually don't have the issue of liquidity. Instead when they are wrong they have to deal almost instantly with price shock as prices will usually experience rapid decline. Usually though you can get out by selling. Do so! This is dead money with little hope of recovery. Internet investors in March, 2000 didn't like the fact that their investments were halved almost overnight. Most didn't sell even though prices were still at stratospheric levels. They liked it even less when their stocks were worthless a few months later.

A cousin of selling when an investment thesis is wrong is selling on financial irregularities. So far this has not been an issue with ETFs or mutual funds. Maybe some day it will be a problem, but with what we understand today about these investments this is currently less of an issue then it is with equities. Common stocks seem to regularly have this as an issue. It is astounding to me how many companies and their officers are willing to commit financial fraud . It is equally astounding how those who are charged with overseeing industries like accountants or regulatory bodies fail to catch the problems. Jim Cramer of CNBC's Mad Money has a simple rule for this. "Accounting Irregularities = Sell". I think that's a good rule and should be ironclad for all investors. I say this even though an investment showing some sort of financial irregularity will probably mean taking a substantial loss. Again think back to Enron. Investors that bailed at the first sign of accounting problems were better off then those who stubbornly held on while the company collapsed around them. Even if it turns out ultimately that the issue is resolved and the company gets back on track, you usually have the opportunity to get back in at lower prices from where you originally sold.

So take losses when the thesis changes and take losses when there's problems with the company's books. In the long run you'll be better off and so will your portfolio.

Disclaimer: We are covering in this series what we believe is the proper investment procedures regarding the application of capital losses for the 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 you implement any of the 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 tax or investment advice of any kind! Please also note that when discussing the risks regarding ETFs we have no knowledge, nor do we make any guarantees that some of the same issues and risks pertaining to common stocks could ultimately affect ETFs as well. Again please do your own homework or consult with your own financial advisor as to the appropriateness of these securities for your investment.