The markets closed today without the severe daily swings to which we have (almost) become accustomed. The Dow Jones index traded in a fairly tight range and closed up nearly 200 points. Investors can consider that a small victory. The VIX, which measures market volatility (or “investor fear”), closed down nearly 5 points. Another win. Oil prices traded up 24%, which was a one-day record and, setting aside your desires at the gas pump, a very good sign for the commodities market. So, all in all, not a bad day. Welcome to Spring.
We know that we are not out of this crisis. In fact, we think these are still the early days. There is no way to know how long the coronavirus will continue to affect us. That will not be clear until we see the number of new diagnosed cases reduced to zero.
So, we will take this lull in this storm as an opportunity to highlight some investment strategies you may want to consider in a bear market. It’s likely that not all of these will apply to you. But some of them may.
#1 – Do Nothing
Hopefully, you’re chuckling at that. If you are quarantined at home, you might feel that you are doing too much of “nothing.” But we are referring to taking action regarding your portfolio. Values across all asset classes are down significantly. In fact, it may be wise to just avoid looking at the your account values for the time being.
We advocate “do nothing,” because your inclination right now may be to run from the danger you perceive. As we discussed a few days ago, that was the appropriate action for humans for thousands of years. However, it is not appropriate for investors in March of 2020.
Instead, now is the time to wait, to be patient. Wait for the markets to recover. How long will that take, you ask. You know the answer. No one knows. It could be weeks or months. It could be longer. We do know that the average time it takes for the market to recover from a bear market is about 14 months. But this is not your generic bear market. So, expect that it could take longer.
Hunker down and plan to wait it out. If we’ve built a financial plan for you and we’re managing your portfolio, you can wait. Your plan was built to withstand a crisis like this.
#2 – Double Down
This is for the brave among you. Investments are on sale in a way that they have not been in a very long time. If you like to buy things at a discount, here’s your opportunity. If you have been holding on to cash that you won’t need for a few years, then consider investing in your portfolio.
There are a variety of ways to do this. You can invest a lump sum right away. You can invest in tranches over time (e.g. every month, every quarter, etc.) or market triggers (i.e. if/when the Dow hits X, you invest again). You can combine these strategies. The key is to come up with a plan, execute it, and not alter course.
We understand that they very idea of this may make you nauseous. We get. Stay on the sidelines. But, if you are salivating at the idea of buying stocks on sales, this is your opportunity.
#3 – Rebalance
Your actual mix of investments is now probably out of balance with respect to its target mix. We can say that without looking at it, because all asset classes have changed value over the past month. Stocks have fallen significantly in value. Some bonds have also dropped a hit. Money market funds, bank accounts and cash are where they were when this crisis started.
Rebalancing involves selling asset classes which have risen in value and buying those which have lost value, with the intention of bringing your investment mix (or “asset allocation”) back to its desired target. Clients sometimes balk at doing this. Why sell the things that have done well (or less bad)? Because we want to maintain our desired asset allocation. It’s the one we determined was appropriate for you, given your goals, age, investment horizon, need for liquidity, and risk tolerance.
In a normal environment, we rebalance every 12 months. We rarely waver from this practice. However, we’re not in a normal environment right now. So, if you would like to discuss rebalancing your portfolio, please let us know. We can tell you if there would be tax consequences. Transaction costs are generally minimal.
#4 – Tax Loss Harvesting
If your managed portfolio includes a taxable brokerage account, and holdings in that account are currently “underwater” (i.e. they’re worth less today than what you paid for them), there is an opportunity to sell the position, realize a loss, and use the loss for tax purposes. You don’t want to be out the asset class that the investment you sold represents. So, you would immediately buy another security (ETF or mutual fund) that provides the same exposure. Note that it’s important to avoid buying a security that is “substantially identical” to the one you sold for 30 days, in order to avoid the IRS wash sale rule. If you fail to do so, the tax loss is disallowed, and the amount is added to the cost basis of the new fund you purchased.
Here’s an example. You bought fund X for $1,000 a year ago. Your shares in fund X are now worth $800. So, you have a $200 unrealized loss. To harvest this loss, you would sell your shares in fund X. You have now a realized loss of $200. You can use that loss to offset other realized investment gains, or as an offset against ordinary income. Note that the annual limit for offsetting investment losses against income is $3,000. But losses in excess of $3,000 can be used for subsequent tax years.
Now you have $800 to invest in the same asset class that was represented by fund X. Assuming your intent was to have $1,000 in that asset class, you should round up another $200 and invest $1,000 in a fund that is similar to, but, again not “substantially identical” to, the fund you sold. The IRS has not provided much guidance about what these terms mean for investors. But we have been harvesting losses in this manner for many years, and we have never had the IRS question a transaction.
#5 – Roth Conversion
You probably know that there’s a difference between a traditional IRA and a Roth IRA. But, just in case, here’s a quick reminder. A traditional IRA is funded with pre-tax contributions, growth is tax-deferred, and distributions are taxed as ordinary income. In contrast, a Roth IRA is funded with after-tax contributions, growth is tax-free, and distributions are tax-free. Think of a traditional IRA as “pay no taxes now, but pay taxes later”, and a Roth IRA as “pay taxes now, and pay no taxes later”.
Since it’s safe to assume that your traditional IRA has lost value, now may be an ideal time to take some or all of it and move it to your Roth IRA. You will pay less tax than you would have had you done this six months ago. But this strategy only makes sense if you are age 59 ½ or older, and you have cash on hand to pay the income tax you’ll owe on the distribution from your IRA.
Let’s imagine that you own an emerging markets stock fund in your IRA. At the beginning of the year, that fund was worth $100,000. Today it’s worth $67,000, a 33% loss. If you had sold that fund and pulled the proceeds out of your IRA in January, you would have paid taxes on $100,000. But now you can sell it and pay taxes on only $67,000.
You know you want to maintain your exposure to emerging markets, so you take the $67,000 and buy an emerging markets fund in your Roth IRA with the cash. You should also have cash available in the bank to pay the tax on the additional $67,000 of income you’ll have to report. Otherwise, you’ll need to withdraw additional funds from your IRA to pay the taxes, and this makes the IRA-to-Roth conversion less attractive.
Hopefully, emerging markets stocks bounce back to previous, higher values. The net result is that you moved money from an account subject to ordinary income taxes (i.e. your IRA) and moved them into an account that’s tax-free. Further, there are no required minimum distributions for your Roth IRA as there are for your IRA.
We’ve covered five strategies for astute investors. If you have any questions, or would like to learn more about any of these ideas, please let us know. This crisis may have dealt investors a bushel of lemons. But the savvy investor will turn them into lemonade.
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