First Person: Strategies for Managing Stock Losses

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I, like many equity investors, focus much of my attention on gains and how to achieve them. While gains certainly are essential to long-term investing success, I believe that managing stock market losses also can contribute to superior results. I also believe that this aspect of investing in stocks often is overlooked or ignored rather than approached strategically. Here are some of the ways I manage stock losses to reduce taxes and improve returns.

Offset Gains

Perhaps the most obvious way to take advantage of losses in stocks is to use them to offset gains in order to reduce taxes. My most productive use of losses is, if possible, to use them to offset short-term gains, since these gains otherwise would be taxed at ordinary, rather than capital gains, tax rates. However, if my losses can't be used to offset short-term gains, using them to offset long-term gains, which currently may be taxed at as much as 15% (federal), makes sense, since it will boost the realized return on the investment.

Offset Ordinary Income

Alternatively, if I don't have gains to offset with losses, or I have more losses than gains, I can use up to $3,000 of capital losses to offset ordinary income each year. Since ordinary income is, by definition, taxed at ordinary income tax rates, which for many tax payers currently are well above capital gains rates, this also can be a very productive use of losses.

Be Selective

When selling only a portion of a position in a stock in order to take advantage of a loss, I am careful to select specific lots to sell, usually those with the highest purchase price, in order to get the most benefit from the loss.

Be Systematic

Another strategy I use is to take a systematic approach to managing losses by continually tracking all my stock holdings, whether they have gains or losses, so that I can make utilizing losses an integral part of my investment strategy, rather than an afterthought. Another aspect of my loss management strategy is asset allocation--for example, I may put more speculative investments, for which the risk of loss is higher, in taxable accounts where losses, if they occur, can do some good by being used to reduce taxes, rather than in tax-free accounts.

Take Advantage of Losses While Retaining Upside Potential

While taking losses to offset taxable income certainly makes sense, sometimes I am not anxious to sell a stock when it is down. For example, I may be reluctant to sell if I believe that the company's share price has fallen because of temporary market or industry factors, rather than deterioration in the company's prospects, and, therefore, I expect its share price to recover. In that case, I would look for ways to take the loss but still benefit if I'm right that pressures on the stock are likely to ease.

One strategy I might use is to take my loss but immediately buy shares in a substantially similar company in the same industry that I believe will benefit if the market or industry pressures abate. Another alternative is to buy back the shares I sold 31 days or more after the sale. This avoids running afoul of the "wash sale rule," which says that an investor cannot take a tax loss on shares if he purchased the same shares within 30 days (before or after) realizing the loss.

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