It is always an unsettling time for investors when the markets have a big drop. Many want to do something or really, anything, just because it feels better to be acting as opposed to doing nothing. Unfortunately, many times the emotionally fueled actions are counterproductive. So, if you want to do "something," look at the following actions that may actually do some good in the long run.
1. Use Tax-Loss Harvesting
If some of your stocks or investments in taxable accounts are trading below where you bought them you can sell them and realize losses. These losses can be applied to offset any realized gains. If you have more losses than gains in any given tax year, you can use up to $3,000 of those losses to offset your ordinary income. Any additional losses can be carried forward to use in future years. This is called making lemonade out of lemons…
2. Consider Roth Conversions
At RSWA, we look to build up our client’s Roth assets any chance we get. Market downturns present an opportunity to increase your Roth assets by converting portions of your assets held in pre-tax traditional IRA accounts into an after-tax Roth IRA.
A Roth conversion results in paying taxes on the assets being converted in the year the conversion takes place. All pre-tax contributions and account earnings will be subject to taxes as a result of the conversion. If you convert pre-tax money in a year that the market is down, you would be paying tax on a lower amount, therefore theoretically leading to a lower tax bill. Those converted assets would then be reinvested in the Roth IRA and can recover as the market bounces back. Later on, as funds are needed from your Roth, you can withdraw that money tax-free.
(Visit our article on Roth IRAs for more information on rules and strategies regarding contributing to a Roth IRA)
3. Reduce a Concentrated Position
Many investors have an outsized position in one or two stocks. Sometimes the stocks are inherited or accumulated from working at a company that issued stock for compensation or incentive. Large positions in one or two stocks could very negatively impact your overall portfolio if those stocks significantly lag the market over a long time or worse yet, go bankrupt. Usually, the biggest impediment to selling a big position is paying tax on the realized capital gain from selling. A big market downturn may make reducing the concentrated position more palatable by lowering the capital gain. The after-tax proceeds can be invested in a more diversified stock investment allowing you to participate in stock market returns but lowering your single-company risks. Read more on strategies to reduce your concentrated stock position here: 7 Strategies for Dealing With Your Concentrated Stock Position.
4. Rebalance Your Portfolio
If you have a target percentage of stocks to own in your portfolio, it may be time to rebalance after a big market drop. For example, if the original plan for your portfolio was to have 50% stocks and 50% bonds, you may find stocks well below their target after a selloff. If the portfolio is now at 40% stocks and 60% bonds, sell bonds and buy stocks to get back to the original 50% target for each. Effectively you are hoping to buy stocks when they are down and cheaper. This also works when stocks rally and your portfolio becomes overweight in stocks. In that example you sell some stocks when they are priced high, locking in your gains. You will want to know in advance how far you are willing to let your portfolio stray from the target, such as 5%, 10%, etc. Rebalancing is triggered when you reach whatever threshold you have set. Deciding when to to buy and sell investments becomes a well-planned out and systematic decision, rather than an emotional one. And if you don't have a target…
5. Reassess Your Risk & Create a Plan
Most investors are much more comfortable with risk when the markets are doing well. You will only truly know how comfortable you are with volatility during a bad market. If you find yourself unable to handle the ups and downs of a bad stock market, it is probably time to reassess your stock exposure. This doesn't mean you get to the point where you are whistling when the markets drop big. But you must be able to live with volatility and sleep at night with the confidence that you have the right mix of volatile and less-volatile investments.
6. Trade Up in Quality
Often when there is a sharp stock correction, all stocks go down, both good and bad. Investments that you liked previously but were too expensive may now be in your price range. If this happens, you will have an opportunity to trade up in quality. Proceeds from selling mediocre investments can be used to purchase higher quality investments and ultimately create a stronger portfolio.
7. Invest Cash
Usually, when a stock market is bad it is because the economy is not doing well. You always want to have an emergency cash fund to cover monthly expenses and potentially one or two unexpected expenses (a new car, a roof for the house, etc.). But if you have an adequate emergency cash fund and your cash flow is secure to cover monthly expenses, a stock market correction just may be a good time to invest cash for the long-term. Also, it may be a perfect time to invest your yearly IRA or Roth IRA contributions, if you are eligible to do so. If you are nervous about investing all your cash at once, consider investing a set amount over time, such as monthly. Pick a time frame that feels comfortable for you whether that's three, six, twelve months, or more. Dollar-cost averaging is a great way to start buying in but not worrying if your new investment will immediately lose value because you'll be investing more soon.
As investors in stocks, we must periodically stomach very bad markets. Volatility is the price we pay in order to hopefully participate in higher, long-term returns. But when stocks take a hit, there are some positive things you can do to help you and your portfolio in the long run.
