What To Do After A Large Stock Market Drop?
“The stock market dropped, what should I do?” Due to the recent market downturn, it is a question being asked of financial advisors by investor clients. The common answer is to ‘stay the course’, ‘stick to the plan or simply ‘do nothing.’ We, at KCAM agree. This advice is largely sound - the intended message being, “don’t panic sell.” Selling during a decline is the easiest way to make losses permanent thereby ensuring that you’ll miss out as the market recovers. This is true because stocks have a long history of providing handsome returns over long periods of time.
We all hear the anecdotal stories -“my Aunt lost so much money in 2008/2009,” “my Cousin Jim lost his retirement because the market crashed.” Well, if these stories are true, thats because Auntie and Cousin Jim sold their investments when they were down (or made some other odd investment choices), thereby making sure they couldn’t participate as stock prices inevitably rose. Those who held on for the ride made out just fine, perhaps with a few more gray hairs, but in a superior long term position to those who locked in their losses by panic-selling.
So, yes, “holding on for the ride” is generally good advice. However, there is more to the analysis, and diving in a little bit further can really benefit you greatly. Before we get into a few of our best ideas, let’s take a step back and gain some perspective. If you are a younger investor - 40 and under - this decline is exactly what you should have hoped for. While it feels good to see your balances increase in your 401k or investment account, you likely will invest more money in the future than you already have saved. Your fortunate timing will allow you to accumulate more shares at lower prices while the market is down. When you reach your financial destination in 20, 30 or even 40 years, you’ll look back with knowing satisfaction that you invested wisely.
For those closer to or already in retirement, and who received and followed sound advice, you likely have a significant allocation of your investments in bonds. Bonds have fared well during this decline. As interest rates have fallen, the value of those relatively higher interest bearing bonds that you already owned have increased. You are well positioned to take needed withdrawals for living expenses from the bond portion of your account for many years. An added bonus is that you do not need to sell stocks that have declined in value to cover your income needs. Although it is not easy to watch balances decline, having the right mentality and understanding your strategy makes a big difference (also in fewer number of grey hairs).
Tactical Strategies That Make Sense
Rebalancing– We advise our clients to routinely rebalance their portfolios. Once our clients agree to this strategy, we monitor portfolios and do the trade executions necessary to keep portfolios well balanced. We typically do this on a quarterly basis for client portfolios. For the last decade or so, that has largely meant selling some appreciated stocks each quarter, and putting that money into bonds, to bring the portfolio back to agreed target allocations. After a decline, if you aren’t relying on your bonds to provide current income or near-term income (as discussed earlier), this is an opportunity to sell those bonds at a relatively high price, and buy stocks that have dropped in value. This routine maintenance will pay off over time and we are currently actively rebalancing portfolios to make sure you stay on track.
Tax Loss Harvesting – Tax-loss harvesting is a tax strategy for investments that are worth less now than when you paid for them. While you hold an investment, any gains or losses don’t count for tax purposes. The tax man only comes knocking once an investment is actually sold. For investments with a current loss, selling it and replacing it with a similar one can be a very smart way to lower your future tax bill. We know what you’re thinking, ‘But you just said I shouldn’t sell now?” And you are absolutely correct. However, the strategy is to sell the loser, immediately take the proceeds and replace that loser with a substantially similar stock – think swapping Lowe’s for Home Depot or Coke for Pepsi. We use these near equivalents to allow your resulting portfolio to look and feel very similar to the portfolio you had before the sale. We use the losses generated from selling the loser to offset future taxes. Here’s a simple example: If you held Coke and it was down, we’d sell the Coke shares and immediately buy Pepsi. As markets recover, both Coke and Pepsi likely will also recover and at comparable rates. As markets recover you would now have a valuable recognized tax loss from the Coke sale and appreciation in Pepsi. Those recognized losses can be used as tax deductions each year to offset other capital gains or in the absence of any other gains, as a $3,000 per year deduction until depleted. By employing tax loss harvesting you will have positioned yourself better as compared to just holding Coke on the way down and on the way back up.
Roth Conversions – A Roth conversion involves moving money from a tax-deferred source (IRAs, 401ks, SEP, SIMPLE etc) to a tax-exempt destination, a Roth IRA. Making this type of transfer creates a current tax for the amount being converted from the source account while allowing the transferred assets to reflate in an account where there will likely never be any further taxes. The strategy creates value for you because as IRAs decrease in value, so too have their embedded tax liabilities. Doing a conversion while these balances are low and allowing the subsequent appreciation of the transferred assets to take place in a tax-exempt account can create enormous value. There are current tax considerations to keep in mind, of course, and an analysis should be done to make individual determinations. Those who may particularly benefit are those who will be in a lower tax bracket this year:
1. Couples who have joint income of less than $78,950 after deductions and individuals who have less than $39,475 of income after deductions. These are often people who are post-retirement, but pre-social security;
2. Those who had a decrease in income in 2020 that may have them in a temporarily lower marginal tax bracket;
3. Those with Required Minimum Distributions, which were suspended for 2020;
4. Those who think they are likely to be in a higher tax bracket in the future than they are now.
At KCAM, we know that the roller coaster ride of investing hard earned money can be scary, especially when the coaster is not a kid-ride. We also know that you are already in a good position, having planned for your future by building a portfolio designed for the long haul. Events like the Covid-19 pandemic can feel like a twisting double loop. We can assure you of two certainties: 1. You’re very unlikely to get hurt on a roller coaster ride as long as you don’t jump off mid-ride, and 2. There are steps that you can take, other than raising your arms up and screaming at the top of your lungs, to make the ride work to your advantage. If you have any further questions, please don’t hesitate to reach out Michael Cocozza at MCocozza@KaganCocozza.com anytime.