That emotion is, of course, ridiculous but nonetheless very real.

And like the gambler who keeps betting a losing streak, it’s always emotionally easier to just hold and hope for our luck to change, rather than cutting our losses and moving on. As a result, many--if not most--of us have a tendency to stick too long with a losing investment. And all too often, the losers just keep right on losing, costing us money and keeping us from playing the games where we have a better than fair chance of winning.

Those who rely purely on technical indicators for buying and selling have no such problem. They always buy when something’s going up and sell it when it goes down. Some employ stop losses, which simply take you out of a position that loses ground, without any need to make a decision on whether that makes sense or not.

Unfortunately, as income investors we don’t have that luxury. Yes, I’ve heard from some readers that they have hard-and-fast rules for selling anything that loses 10 percent or 20 percent from their purchase price. And if that really works for you, more power to you.

My experience, however, has been that such strategies leave investors vulnerable to being whipsawed, i.e. stopped out of positions that take a temporary dive only to shoot back up again.

That actually happens relatively often in volatile markets, sometimes by design when traders and market makers notice a large number of stops at a particular level and drive prices down to take them out.

In any case, a winning income investing strategy is incompatible with trading. And the more a strategy resembles trading, the less effective it will be.

For one thing, to garner a dividend, you’ve got to buy and hold at least through the ex-dividend date--and longer than that if you want to get the preferential 15 percent qualified dividend rate. One could conceivably avoid the tax burden by buying and selling income investments within an IRA. But you’d still incur commissions and a lot of headaches trying to time entries and exits. In the end, 99 percent of us would come out losers.

Also, one of the greatest benefits of owning an income investment is appreciation. A company backed by a solid business will increase its dividend over time, and its share price will follow the payout higher. A bond or preferred stock backed by a strengthening business will also gain ground, as the market rewards it for increased creditworthiness.

Long-term appreciation isn’t something you’ll get if you trade income investments. In fact, every time you buy back a security backed by a strong business, chances are you’ll be paying a higher price.

HOW TO STICK

How do you stick around and avoid holding losers too long? It really boils down to two things.

First, every individual income investment you own should be backed by a high-quality business. Again and again, I’ve seen investors jump for the stocks with the biggest current yields, only to be later burned when the reason for the big number--namely big risk--became apparent.

In contrast, a good business will always endure, even if its overall sector takes a shellacking. You can always be confident the shares of a good business will ultimately recover from a blow in the market place.

That was the clear lesson from the historic 2001-02 bear market in the utility sector. At one point, it seemed like even the strongest utilities were doomed in the wake of the Enron bankruptcy, a chronic overbuilding of power plants, the weakening economy, a regulatory clamp down and the industry’s mountain of teetering debt.

A couple of years later, however, the best were again pushing new highs. In fact, the sector enjoyed its strongest two-year bull run in history from mid-2003 through mid-2005. A few of the industry players didn’t make it, but those that did have thrown off incredible profits, even to investors who got in a year or so after the late 2002 lows.

The clear lesson: If you buy companies backed by good businesses, you’ll always be in the game. And over the long pull, your wealth will steadily grow as the market rewards continued growth in cash flow and dividends, regardless of sector ups and downs.

As for sector volatility, every income portfolio should be comprised of a mix of investments. Here in late 2006, that means owning some power utilities, gas utilities, telecoms, bonds and preferred stocks of strengthening companies, real estate investment trusts (REITs), bank stocks, shares of high-yielding conglomerates, limited partnerships (LPs), Super Oil stocks, convertibles into stocks of good industrial companies, foreign high-yielding stocks, foreign bonds or funds and Canadian royalty and income trusts.

These investments hail from a very wide range of markets. At any given time, some will be performing well while others will lag. That will keep your overall portfolio on generally level ground.

Further, if a particular group or sector takes a hit from an unforeseeable event, owning it in balance with others holds down the damage to the overall portfolio. In fact, it’s likely the other sectors will gain as investors stream out of the affected sector seeking high-yielding alternatives.

That appears to have happened this past month with Canadian trusts.

After promising in their campaign earlier this year not to tax the trusts, the Conservative government flip-flopped, issuing a Halloween night declaration that it would indeed begin taxation in 2011 for existing trusts, while slamming the door on new conversions immediately.

The proposal sent the trust market crashing the very next day, and trusts have spent the last month-plus trying to claw their way back.

US utility stocks, however, have spent the last month making one new high after another, as investors have sought them as a safe haven.

REITs have also gained ground, as have a host of other income investments.

The upshot is balanced income portfolios probably gained more in November than they lost in the trust debacle. That should apply to anyone who followed my standing advice of holding trust investments to 20 percent of portfolios. In contrast, those who were heavily concentrated in trusts lost big. Unfortunately, that includes some US investors, though the biggest losers were Canadian investors--some of whom had 100 percent trusts in their portfolio--and who’ve seen their life savings decimated. They won’t recover completely unless the government completely abandons its tax plan, which I wouldn’t lay odds on at this point.

The same kind of disaster can strike any type of income investment.

Pipeline LPs offer high income from solid, fee-based assets, but they wouldn’t if the US government decided to shake up the rules as it did in the late 1980s to curb the growth of non-energy LPs. US power utilities are flying high now, but how long would that last if the “we demand reliable power but don’t want to pay for it” crowd gets into power in the state where the company you own operates?

Long-term bonds are doing well with interest rates low and economy slowing, but what about when inflation raises its ugly head?

I think you get the point by now. It’s an income investing world and we all need yield. But literally any sector can take a hit out of the blue at any time. The only way we protect ourselves is by diversifying among many different sectors.

Also, when a sector does get hit, the worst thing you can do is wholly abandon it in the heat of an emotional reaction, which will probably be a mixture of disgust, anger, fear and panic. Rather, you re-evaluate your holdings in that sector, make sure they’re still high quality businesses and make swaps if they don’t measure up.

When REITs roared back from their late ’90s swoon, the biggest winners were those who with some adjustments kept their investment in the sector. When utilities recovered from the 2001-02 debacle to hit new high after new high, those who tweaked their portfolios but held firm at the lows enjoyed the biggest gains the sector had ever seen. And buying and tacking is the right course for those who now hold Canadian trusts in diversified portfolios as well.

HOW TO SELL

If you stick to income investments backed by strong businesses and pick from a range of industries, your portfolio will weather anything. Even the impact of volatile interest rates--forever the bane of the income seeker--can be offset by focusing on growing businesses and holding some inflation beneficiaries like Super Oils and Canadian trusts, as well as fixed income with short duration or rate risk.

There will be times, however, when it makes sense to sell an individual security or two. First, I sell when anything appreciates to the point where it’s a disproportionately large part of my holdings. Second, I want to sell any income investment when the underlying business is weakening.

The first circumstance is obviously preferable to the second, as it implies taking a profit. A strategy of trying to maintain portfolio balance always ensures you will take profits at good prices, as you’ll basically have little choice but to do so.

It’s critical, however, for a wholly different reason. That is, when a particular stock, bond or fund becomes over-weighted in your portfolio, its potential to drag down your entire portfolio is magnified. That, unfortunately, is what happened to some investors in the Canadian trusts who became dramatically over-weighted as the sector moved higher. And it’s bound to eventually happen to anyone who becomes more and more wedded to any bull market as it goes up--i.e., by becoming ever more weighted and therefore dependent on it continuing.

Even if you’re evenly weighted among sectors, it’s important to sell when a holding’s fundamentals deteriorate. That’s hard enough when the market overall is on solid footing and prices are relatively high.

A stable price in good times doesn’t necessarily mean everything is OK. In fact, an overall bouncy market can mask real trouble with an individual holding. But a steady price does make it pretty easy to rationalize that everything is OK, keeping you from selling when you should.

That’s one reason I pay so much attention to actual financial results. I want to know a company’s becoming more valuable. And if it’s not, I want to go to something in the same sector that is.

Selling when fundamentals deteriorate, however, is infinitely more difficult when prices are falling. As I said at the outset of this article, it’s tough to admit when you’ve made a mistake, but particularly when there’s a loss involved. The reality is the security is already down and will stay there or go lower, unless there’s a very good reason it will recover.

In an overall sector crash, the odds of a recovery are good, provided the underlying business of the investment is still healthy.

The critical thing to determine is just how healthy the business is, and being honest enough with yourself to not let other considerations--mainly the stock’s near-term performance--cloud your judgment.

I’ve found that to be a tall order, even after 20 years in the investment advisory business. So I’ve added another caveat to my rule: If I can find an investment in a bombed-out sector that has better fundamentals than what I’m holding, my bias is toward swapping unless I find a pretty compelling reason not to.

For one thing, buying something similar keeps me in the game if the overall sector turns up. At the same time, owning a stronger entity is better protection against the sector deteriorating further. And since everything goes down in a sector correction, chances are I won’t pay up for the higher quality.

December is the ideal month to make swaps, particularly in a sector that’s headed south during the year. For one thing, you can cash out losing positions and take advantage of the tax losses to balance off against any gains you might have had during the year. And again, since a sector correction takes down even the strongest, you can move into them cheaply and before investors start buying again in January.

What I’m leading up to is December 2006 is the ideal time for swaps with Canadian income trusts. If you’ve taken a real beating on a particular trust, this is the ideal time to unload it, and buy back something of higher quality. One example would be to sell trusts yielding 16 percent or more and buy ENERPLUS RESOURCES (NYSE: ERF), which yields less, but is an infinitely stronger business.

One group investors can balance the losses off against is utilities.

I’m still extremely bullish on this group’s prospects over the next several years. Regulation remains very positive, market conditions are tightening and finances are improving. But because the stocks have been off to the races, I suspect at least some investors’ portfolios are too heavily weighted toward them.

Just as December is traditionally a very strong month for utilities, so are January and February often weak ones. Taking some money off the table now and simultaneously selling some weak trusts will lock in gains, reduce exposure brought on by overweighting and allow the opportunity to buy back in at lower prices, if traditional seasonal patterns repeat.

The REIT sector is another group from which to consider taking profits. With the exception of Canadian REITs and US apartment REITs, the sector has gotten even more expensive during the past year. If you have a REIT yielding less than 3 percent, it’s time to book the gain.