For many individuals, market fluctuations initiate thoughts of concern and worry and create a desire to avoid the uncomfortable psychological effects of market volatility. The natural response for many individuals is to attempt to time the market by selling before it falls and buying back in before it recovers.
As we discussed in last month’s blog post, “Investing During Uncertain Times,” market timing is an impossible task that requires the market timer to be right twice, when to get out and when to get back in. No one has been able to consistently time the markets over the long term.
While timing the market is a poor strategy, we do not recommend sitting idly by during market fluctuations. In fact, there are many financial planning opportunities that market fluctuations present, and the patient investor can capitalize on them.
Key Takeaway:
Timing the market is a poor investment strategy, but market fluctuations still provide many opportunities for the savvy investor.
Opportunities During Market Downturns
Rebalancing: Portfolio rebalancing on a systematic basis is one way to take advantage of market downturns. In a properly diversified portfolio, there will be asset classes that decline more than others – especially if the portfolio includes a short-term fixed income or cash component.
When markets have declined, rebalancing shifts some of the investments from assets that have not declined or declined less into the investments that have declined substantially . This brings the overall allocation back into alignment and shifts a portion the portfolio into assets that have more potential upside as the markets recover.
The following graph demonstrates the value this can create. For simplicity consider a portfolio of two asset classes, fixed income and stocks. The portfolio value is $100 and is evenly allocated between fixed income and stocks prior to the market downturn. When the market declines, the fixed income position declines by 10% and stocks decline by 50%. After the decline, the portfolio is rebalanced so that it once again is evenly allocated between fixed income and stocks.
After rebalancing, both fixed income and stocks recover to their pre-decline levels consistent with historical precedent (although the future is never guaranteed). In this case stocks must double to make up for their 50% decline and fixed income must increase by 11%.
As the graph shows, rebalancing during the market downturn shifted a portion of the fixed income assets into stocks. As stocks recovered, the total value of the investor’s portfolio increased to $108 despite the stock and fixed income markets finishing exactly where they started.
Accordingly, rebalancing added 8% in overall value to the investor’s portfolio and provides an opportunity for the individual investor to take advantage of market declines.
Key Takeaway:
Rebalancing during market downturns can result in portfolio growth even if the market simply returns to its initial level.
Roth Conversions: Pre-tax employer retirement accounts and traditional IRAs represent money that will eventually be taxable when withdrawn. The larger the pre-tax account, the more tax that will eventually be owed.
For those who have the cash available to pay the taxes, it is often a great approach to do Roth conversions during a market downturn . The market decline will reduce the value of the pre-tax account which will correspondingly reduce the amount of taxable income resulting from the conversion.
For example, consider a $100,000 traditional IRA account that is pre-tax, and an investor whose combined federal and state tax rate is 40%. If that IRA was fully converted to a Roth account, the total tax would be $40,000.
Alternatively, if the investor waited for a 30% market decline and then converted the balance to a Roth account, the total tax due would only be $28,000. That represents $12,000 in tax savings. After the conversion, the balance would be in a Roth account which allows the subsequent market recovery to occur tax free.
Although Roth conversions are taxable events, converting during a market downturn will reduce the total taxes paid on pre-tax IRA balances over the investor’s lifetime.
Key Takeaway:
Completing Roth conversions during market downturns results in less taxable income and allows any subsequent market recovery to occur in a tax-free Roth account.
Tax Loss Harvesting: Investments in taxable brokerage accounts that have declined in value present opportunities to harvest capital losses by selling those positions and recognizing the loss for tax purposes.
Harvesting capital losses provides substantial long-term benefits. Any capital losses can be used to offset future capital gains and up to $3,000 of ordinary income each year. This can substantially increase the tax efficiency of an investor’s portfolio and reduce the taxes owed each year.
!!! Important Note !!! Wash sale rules impact tax loss harvesting and require that the position sold at a loss is not repurchased within 30 days before or after the sale.
A common strategy is to purchase a similar (but not substantially identical) investment during that 30-day period. While the IRS has not defined the term “substantially identical,” the general consensus is that an individual will avoid the wash sale rules if they sell stock in one company and repurchase stock in a different company or if they sell one fund and purchase shares in another fund that tracks a different benchmark. For example, the investor may choose to sell stock in Lowe’s and replace it with the stock of Home Depot or they might sell a US Large Cap Growth fund and repurchase a US Large Cap Value fund. This allows the investor to continue participating in market returns without violating the wash sale rules.
Additional Investing: While we recommend that individuals invest consistently in the market over time, we encourage increasing the amounts invested when markets are down. While market downturns are always unsettling, they represent an opportunity to purchase investments at a discount. Those who invest more during market downturns will likely have better long-term performance.
When determining how much to invest during market downturns, it is important to maintain an adequate emergency fund which will cover any necessary or unexpected expenses. Market downturns typically occur during periods of substantial uncertainty; so never risk an amount that may be needed in the short-term for a long-term investment.
For individuals who have a sufficient emergency fund in place, using excess funds to accelerate investing is a recommended approach.
Key Takeaway:
A coordinated approach to portfolio rebalancing, Roth conversions, tax loss harvesting, and additional investing can add substantial value during market downturns.
Opportunities During Market Highs
Rebalancing: Rebalancing is also important when markets are at their highest. By shifting investments from the assets that have significantly appreciated and potentially are overvalued to assets which have not appreciated nearly as much, investors are able to reposition their portfolio to reduce risk and ensure proper diversification.
Gifting Appreciated Stock: During markets highs, it is often unattractive to sell highly appreciated stock and pay the related capital gains tax. Stocks that have been held for over 1 year can be gifted to charity instead of giving cash to avoid capital gains taxes .
The full fair market value of the gifted stock is eligible as an itemized deduction for tax purposes. Gifting appreciated stock is a great way to take advantage of market highs for those who are already charitably inclined.
Qualified Charitable Distributions from IRAs: Market highs increase IRA balances which means the amount of pre-tax money that will eventually be taxed is larger. Individuals who are over 70 ½ years old are able to make contributions to charity directly from their IRA accounts. These distributions are called Qualified Charitable Distributions (QCDs), and they completely avoid taxation.
Individuals who have reached age 72, can also use QCDs to satisfy all or a portion of their required minimum distributions (RMDs) from their IRA accounts. This allows the individuals to satisfy their RMD requirement without generating any taxable income to themselves.
Key Takeaway:
Market appreciation accentuates capital gains and increases IRA account balances which highlights the importance of coordinating charitable giving and tax strategies.
Estate Planning/Gifting Strategies: As markets reach their highs, it is important to ensure the proper estate planning strategies are in place and up to date. Lifetime exclusions often are exceeded when markets perform well which can leave an individual’s assets subject to estate tax when they pass away.
While current federal lifetime exemptions are high at $12,060,000 per person in 2022 and allow for portability between spouses , they are expected to be cut in half at the end of 2025. Further there are proposals that may lower them sooner and more substantially.
Certain states also have their own estate tax with lower exemptions such as Minnesota with a current estate exemption of only $3M. State exemptions can often impact non-residents as well who own property in the state such as a vacation home or lake cabin.
It is important for individuals to keep these exemptions in mind as their assets appreciate so that they employ the proper estate planning strategies to reduce any potential estate tax that they may eventually owe.
Conclusion
While moving in and out of the market in an attempt to avoid market downturns is a speculative and dangerous long-term strategy, we do believe market fluctuations provide opportunities for individuals to make informed financial planning decisions.
Taking advantage of the opportunities that market fluctuations present offers investors a way to use market fluctuations to their advantage without risking the long-term outcome of their financial future.
If you are interested in learning more about market fluctuations and the opportunities they provide for achieving your financial goals, we would love to connect to see if what we do is right for you
