“There are risks and costs to action. But they are far less than the long range risks of comfortable inaction.” - John F Kennedy
During times of economic uncertainty and heightened market volatility, similar to what we’ve experienced thus far in 2020, the phrase “stay the course,” an expression meant to instill an apathetic and lifeless approach towards investing, begins to echo loudly amongst the financial community. This "close your eyes and do nothing"tactic may sound good on paper, but in reality is better fit for a fortune cookie than in the pantheon of sage-like financial guidance.
The underlying problem with this phrase is its perception by some as sound investment advice. You’re made to think whatever happens in the market, you should stand still, hold on for dear life and and pray your investments rise back to their original value. You’re told to remain calm. You’re told not to look at your account. While there is SOME truth to this (The calm part), the reality is “stay the course” is terrible investment advice and if followed, likely to result in missed opportunities to increase your wealth.
The phrase “stay the course” has, over time become confused with “buy and hold,” an investment strategy made popular by billionaire investor Warren Buffet who’s quoted by saying his favorite holding period for an investment is “forever.”
I was made aware of this confusion when I asked retirees, just like you, what they do when the market and/or their investments drop, say 30% in two weeks. I did this recently and their responses were all the same: “We just stay the course. We’re in it for the long haul. Isn’t that what you’re supposed to do?” Well, yes and no.
While it’s been proven that investing in good quality companies for long periods of time (Buy and hold) is a vastly superior approach to short-term trading and market timing, blindly holding on to your investments and ignoring the glaringly obvious opportunities that can emerge from a falling or rising market is just plain lazy and foolish.
The fact is, major swings up or down in the stock market can be the perfect time for investors to consider taking action in their portfolios by using simple, effective investment strategies that can result in more money, lower taxes and optimal long-term performance.
The historical selloff in stocks as a result of COVID-19 may indeed be the black swan event of our time, but that isn’t to say the volatility is through. Markets can be harsh, irrational and nonsensical, the latter of which most aptly describes the historic and unexpected resurgence in stock prices amidst retail bankruptcy filings, rising debt levels and a 13% unemployment rate. Disney literally saw their parks revenue drop from several billion dollars to zero, and their stock is only off 1% year-to-date. Really?
Point is, the mounting comeback in stocks can, and will go the other way at some point, regardless of unemployment, interest rates, and park attendance at Magic Kingdom. And there’s nothing you can do to control it. What you can do, however, is be better prepared when the next big spike, or drop occurs and consider implementing the following strategies in your portfolio:
Rebalance
Rebalancing your portfolio is a simple investment strategy that consists of adjusting your stock and bond weightings back to their initial objective. This not only ensures your investment strategy remains aligned with your financial goals and tolerance for risk, but allows you to benefit from buying securities at favorable prices, thereby putting more money in your pocket over the long-term.
For example, say you took an online risk tolerance questionnaire and determined the ideal allocation for your IRA is to have 60% invested in equities and 40% in fixed income. This then becomes your investment objective, or target for which all investment decisions in your IRA revolve around.
After your investment objective is set and allocated appropriately, the stock market drops 25% due to fear of a global pandemic and your portfolio now looks more like 52% in stocks, 48% bonds. Being the savvy investor you are, you decide to rebalance your portfolio by selling a portion of your bonds and using the proceeds to buy stocks, thereby adjusting your weightings back to the original target of 60/40.
Several months pass and the market has now risen 15% off its lows. Your stock weighting has increased to 64% from 52%. You made more money as a result of rebalancing (Bought stocks when they were low, and sold bonds when they were high) than had you done nothing. Your portfolio more closely matches your tolerance for risk than it did before. You smile, pat yourself on the back and live happily ever after while your money continues to grow.
Obviously, this Hallmark-worthy example isn’t reality. Rarely do things go exactly as planned whether in life, or finance. The benefits of rebalancing, however, are real and can add significant value if executed correctly.
Tax-loss Harvest
“I don't like losses, sport. Nothing ruins my day more than losses. Now you do good, you get perks, lots and lots of perks.” - Gordon Gekko from the movie WallStreet
After seeing this movie more times than I care to admit, I finally understand what Michael Douglas was trying to say: “Tax-loss harvest!"
For those who’ve seen the movie and are laughing hysterically at how funny my interpretation is (Crickets…) to those who have no clue what I’m referring to, let me break it down as simply as possible: Tax-loss harvesting occurs when you sell an investment at a loss and use the proceeds to repurchase a similar security.
You may be wondering, “Why on earth would you do that?” The answer to that question can be found on line 6 of your 1040 (2019) where the IRS allows for the deduction of capital losses of up to $3,000 for couples filing a joint return. This means that if you’re in a 28% tax bracket and have realized losses in your investment account of $3,000, you could end up saving roughly $840 in taxes.
The tax savings increase further if you have realized gains from selling appreciated investments as losses can also work to offset capital gains. For example, say you sold Amazon stock this year in your brokerage account for a gain of $50,000. You also purchased an emerging markets fund right before the market tanked, which has declined in value by $25,000. If you sell the emerging markets fund and realize the loss of $25,000, you could save nearly $3,800 in taxes (Assuming a 15% long-term capital gains rate) by being able to reduce your $50,000 gain by the amount of the loss.
But wait, you’re selling something at loss which is greater than the tax benefit. Again you ask, “Why would you do that?” Remember, tax-loss harvesting involves swapping one security for something comparable which, if you think about it, is nearly identical to holding the investment and doing nothing since you remain invested either way.
However, there are caveats, provisos, and a few quid pro quos that must be considered before implementing this strategy.
For one, if you purchase the same or similar security within 30 days of realizing the loss, a wash sale will occur and the loss will be disallowed for tax purposes.
Secondly, the IRS has a very loose definition of “similar,” so it’s important to be careful when exchanging one security for another. Selling Verizon stock at a loss and purchasing a telecommunication services ETF 32 days later may be fine, but replacing one S&P 500 fund for another may not.
And last but not least, tax-loss harvesting only works if you have a taxable account like a brokerage or revocable trust as realized losses created in IRAs or other qualified retirement accounts are not deductible for tax purposes.
Build a Cash Reserve
So far, the focus has been on taking action in your portfolio when the stock market drops, but what about when it rises?
If you’re nearing, or in the distribution phase of retirement and relying on your investments for living expenses, then it’s not a bad idea to begin building a cash position while the market is up. Not only are you locking in gains on appreciated assets, but you’re avoiding the potential need to sell investments during a down market.
Consider the recent 30% drop in the S&P 500 back in March 2020. If you were heavily invested in equities and actively taking distributions from your portfolio, you may have been forced to sell stocks at less than favorable prices to cover your cash needs. Compare this to someone with eight to twelve months’ worth of living expenses sitting in cash who comfortably drew money from their portfolio without having to touch their equity investments. Who do you think will fare better over the long-term?
You’re never going to time it perfectly and know precisely when to buy or sell. But taking a proactive approach towards managing your investments by reducing risk to fund future distributions will provide you more comfort and control over your money, regardless of how the market moves.
What Should I Do Next?
Because everyone’s financial situation is different, it’s impossible to say what if any of these strategies are best suited for you. But regardless of your financial position, it’s important to remember that hoping and praying aren't investment strategies. Having a plan in place and taking strategic action with your investments often breeds results. So the next time the market drops or rises precipitously (And it will), be ready to capitalize on the opportunity to rebalance, harvest losses or conserve cash.
