NEW YORK (TheStreet) -- Even in the best of years there are bound to be some losers. Fortunately, whatever faults there may be in the tax code, the ability to attenuate investment mistakes isn't one of them.
Since I actively sell covered options and generate taxable premiums, the thought of offsetting gains is appealing, but before jumping at the opportunity, let's look at the historical record.
I'm struck by one thing in particular when looking at strategic tax losses taken in 2012. Four of five such sales saw their shares outperform the S&P 500 in 2013. Not only did they gain more than 29% from their sale price, but they also gained more than 29% from their purchase prices.
Proponents of the "Dogs of the Dow Theory" readily understand the phenomenon, as perhaps should serial-covered-option writers who repeatedly opine on the same stocks as prices regularly go up and down, sometimes even to extremes, yet so often recover.
Given the choice between taking a tax credit or a stock loss or paying more taxes because of greater gains, I would take the latter every time. However, there is a preponderance of thought that losses should be taken if they reach the 10% level. For those believing in rules, this is a useful rule, if consistently practiced.
Unfortunately, there is no guarantee that proceeds from the sale of losers will be recycled into the shares of winners. Sometimes losers simply give way to other losers, as even well devised ideas don't always bear fruit. While hindsight often has me wishing I had cut my losses, the real battle is deciding whether to follow your humble or arrogant side.
The arrogant side believes it can reinvest loser proceeds and recover losses. The humble side wonders how someone so ill-advised made the original investment, then sat frozen while shares plunged, could now be deft enough to select a winner, instead of inviting ruination once again.
It's difficult to not take the humble side's argument. Logic trumps hope.
The decision process as to whether to take tax losses begins with understanding your tax liability, which is related to your marginal tax rate. If in the highest federal tax bracket, the short term rate on capital gains is 39.6%, although the rate varies from 10% to 39.6%.
Now, lets look at probabilities: There is a 100% probability that the loss will decrease your tax liability, if you didn't violate the Wash Sales Rules. It's hard to beat those odds, but if you do buy and sell the same stock repeatedly, as I often do, the 30-day window on either side of your proposed trade can scuttle your strategy.
The next step takes some calculation.
For example, let's look at Petrobras (PBR) - Get Report shares that I bought at $20.05 on Jan. 7, 2013 and are currently trading at $13.48. The potential tax benefit is based upon your tax rate and whether the holding is a short term or long term. As a short term holding, the Petrobras position is entitled up to a 39.6% credit against capital gains, meaning that credit can be worth up to $2.60 per share.
While that is an objective calculation, the next step is entirely subjective and focuses on your assessment of the probability that Petrobras shares will add $2.60 to its current share price. How likely is it that shares will gain 19.3%? While there may be be company specific challenges, as well as broader economic challenges to consider, one may be justified in wondering whether Petrobras will be this year's Hewlett Packard (HPQ) - Get Report, a strategic tax loss that I mistakenly took last year and is up 99% in 2013.
If you believe that such lightning may strike twice in a lifetime, you may decide to roll the dice and surrender the certainty of a short-term tax credit.
If your educated gamble is right, even at the new higher price you may still qualify for a tax loss, however, you'll find yourself looking at a much lower credit if the short-term loss becomes a long-term loss. If you can generate some option premiums along the way, you can make your own luck, but whatever the outcome, it is deferred to 2015, which may entail further opportunity costs.
Then again, just look at your losers from last year. Unlikely as it may have seemed at the time, recovery is almost always a possibility.
At the time of publication, the author had a position in PBR, but may sell shares before Jan. 1, 2014.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.