Turning your mutual fund lemons into lemonade

— -- We admire people who look into the eye of adversity, dig in their heels and persevere, no matter what the odds. But in investing, it's best to stare defeat in the face, lace up your sneakers and run screaming into the woods.

Much of financial literature lauds the virtue of long-term buy-and-hold investing, and it's true: If you invest in stocks over very long periods, you typically earn more than you would from less risky investments, such as bank CDs and bonds. If you're willing to hang on through the tough times, your investment rewards can increase with the risks you take. That said, there are some perfectly good reasons to sell, too.

For example, while it's all well and good to hold a diversified portfolio of stocks through booms and busts, specialized stock funds and individual stocks carry far more risk than, say, a fund that tracks the Standard & Poor's 500-stock index.

The axiom that "rewards increase with risk" has limits, just like, "The faster you drive, the sooner you get there." If all you had to do to achieve wealth was to take on more risk, then all financial wisdom would boil down to buying lottery tickets.

If you own stocks or funds with above-average risk, selling is a better option than holding through catastrophic losses, which can lead to the permanent destruction of wealth, not the creation of more of it. After all, if you lose 50%, you then have to earn 100% just to get even.

And a long-term investment outlook doesn't necessarily mean keeping every holding until the bitter end. Some companies become obsolete over time. Of the 500 companies in the index in 1957, for example, only 57 stocks remained by 2007.

In short, there's nothing inherently wrong with selling. And if you hold your stocks or funds in a taxable account, selling has a distinct advantage: You can reap excellent tax benefits from selling your losers.

You can use your losses to offset any amount of long-term capital gains. Let's say you bought 500 shares of Ford 10 years ago. At the time, your shares cost $44.625 apiece, for a total cost of $22,313. At the end of August, you decided you had suffered enough and sold all 500 shares at $4.46 a share. (You didn't reinvest your dividends.) Your proceeds: $2,230 — a loss of $20,083!

On the bright side, let's say you also enjoyed a $10,000 long-term gain from a stock that you feel has peaked. (Most long-term capital gains — the profits on investments sold after more than a year — are taxed at 15%.) Your tax on your $10,000 gain, then, would be $1,500.

Suppose you also had a short-term gain of $5,000 on another stock. (Bear in mind that this is in the magical realm of examples, where people actually saw gains this year.) Short-term gains are taxed at ordinary income tax rates, which, in this case, is 25%. So you'd owe an additional $1,250 on your short-term gain.

Fortunately, your losses will come to your rescue. Your $20,083 loss would offset your $10,000 long-term gain and your $5,000 short-term gain. That would save you $2,750 in taxes. You can deduct an additional $3,000 in losses from your income. Any remaining losses — in this case, $2,083 — can be carried over to your 2009 tax return.

If you're convinced that your loser will someday become a winner, you can buy shares in the company again, though you must wait 30 days. If you repurchase your stock sooner than that, you'll generate what's called a wash sale, and the IRS will disallow your losses.

If you own a mutual fund, you can buy another fund immediately — as long as it's not too close in nature to the fund you sold at a loss. It's probably not a wise idea, for example, to sell your shares of the Vanguard 500 Index fund and buy shares of another fund that tracks the S&P 500. But you could buy shares of the Vanguard International Explorer fund, for example, without running afoul of the wash-sale rules.

If you own a fund that charges an upfront commission, or load, consider moving between funds in the same fund family. Most will let you do so without charging another commission. You could move from the American Funds Growth Fund of America to the American Funds EuroPacific fund, for example, without paying another sales charge. If you move outside the fund family, though, you'll pay an additional sales charge, unless you switch to a no-load fund family.

No one likes losses, and tax relief does only a little to ease your pain. But if you're in a losing investment and you see no hope in sight, then gird your loins, stare disaster right in the eyes and run like crazy.

John Waggoner is a personal finance columnist for USA TODAY and author of 'Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments.' His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.