Action Plans in Downturns
Updated: Dec 29, 2020
The market has fallen significantly, now what?
What a couple of weeks it has been in the stock market. We have had daily returns as high as 9% and as low as -12%, all culminating in a market, as represented by the S&P 500 Index, that is down over 30% from it's very recent peak. The free fall may have you somewhat paralyzed or panicked. Listed below are a few ideas for marginal actions that you can take and benefit from:
1) Tax Loss Harvesting: Do you have investments outside of your retirement account in a taxable investment account that are now down significantly? Try selling them and buying an investment vehicle that captures a similar exposure. For example, if you hold a fund or ETF that is tracking the S&P 500 Index, there are plenty of comparable funds that capture large cap U.S. exposure that you could swap it with and benefit from realizing the investment loss on your current holding. This will then be a positive when the 2020 tax season comes around and you can count the $X loss against any gains you may take later in 2020 or against up to $3000 of ordinary income. (Note: The tax swap can't be into what is deemed to be an identical investment product i.e. you can't sell a S&P 500 ETF from one investment management company and buy a S&P 500 ETF from another investment management company benefit from the realized loss)
2) Re-balancing: After such a drastic move in the markets, your retirement account allocations are likely relatively far from the target allocations that you have set. If you hold some bonds, your allocation to stocks is probably well below where your target allocation is. Now could be a good time to re-balance to those targets by selling bonds and buying stocks at a price that is over 30% below where it was a month ago (it should be very easy to do this within your retirement plan's platform). Systematic re-balancing helps to avoid investment decisions driven by emotion.
While stocks may continue to fall from here in the near future, subsequent 1 year periods following draw-downs of 20% or more have positive returns 86% of the time, when looking at the S&P 500 Index back to 1950. Additionally, the average subsequent 3 year annual return following such declines is 10% per year. Thinking about it another way, if you buy the S&P 500 Index today, and it returns to its February 2020 peak 5 years from now, you will have earned nearly 9% annually on your investment.
You cannot call the bottom, and if you do it is probably luck, but you can buy stocks when they are significantly cheaper than they were in just the recent past. Buying stocks after large declines when you have a long-term time horizon has always been a winning formula.
If you do not hold any bonds, it can still be beneficial to re-balance back to your targets if you are holding multiple funds and they are far from their target allocations.
3) Roth Conversion: If you have a small 401k from say a previous employer, or a traditional IRA, now could be a good time to think about converting it to a Roth IRA. As discussed in previous newsletters, the Roth IRA is beneficial to young investors who have a relatively low income tax bracket. Money is contributed to the Roth that has already been taxed and, when future withdrawals from the Roth are made in retirement, the proceeds are tax exempt. Having both traditional and Roth IRA accounts to draw from in retirement can be advantageous for managing taxes down the line.
In a Roth conversion, the balance of the account being converted is taxed as ordinary income, but you won't have to pay taxes on that money in the future. As a result, it is important to consider the impact of paying taxes on the converted balance. If you are interested in such a conversion, make sure that you comfortably have the cash on hand to pay those taxes, that the balance does not put you in a higher tax bracket, and that the balance does not put you over the contribution phase-out threshold of $126,000 in income. Through a Roth conversion, you are essentially paying taxes now on a deflated asset and never paying taxes on it again.