Market downturns are difficult for us as investors. As account balances fall, our confidence may as well. It can seem as if we are backtracking on progress, moving farther away from realizing our goals, or risking our financial well-being by continuing to invest. As negative returns turn to negative thoughts, our compulsion to act increases. We want to do something to stop the metaphorical bleeding.
In these moments, the worst thing we can do is retreat from the market by cashing out. This locks in our losses and eliminates the potential for asset values to rebound when market conditions improve. But that doesn’t mean we can’t take any action. In fact, there are a few wise financial moves to consider when the market is down.
Invest New Cash
This one is straightforward. Investing new cash after investment prices have come down enables us to buy more shares for fewer dollars. If we believe the investment will rebound, buying in during down markets can be beneficial.
The key is to let go of the notion that we are going to buy in at the bottom of the market. There is no consistent way to detect that we are buying in at the lowest price or to know when the market is about to take a turn for the positive. If you are concerned about investing when the market may continue to fall, consider dollar-cost averaging, or deploying new cash into the market at specified intervals, say monthly, so you can buy in at several different price points.
Harvest Tax Losses
In non-retirement, taxable brokerage accounts, taxes are incurred when we sell an investment for more than we paid for it. If we bought 100 shares of ABC at $20 and sold it for $30, we would have a $10 per share capital gain that would be counted as taxable income. Conversely, if we bought ABC for $20 and it fell to $15, we would have a $5 per share capital loss.
This loss can be used to offset gains from other stocks that we sell for a profit. If we don’t have other gains, up to $3,000 of the losses can be used as a deduction against other income like salaries or IRA withdrawals. Unused losses can be carried forward to future years.
While we typically avoid selling an investment while it is down to avoid locking in the losses, it can make sense to intentionally sell an investment at a loss to harvest the tax benefit, then use the proceeds to buy a similar investment that is also down in price. In this way, the risk and return profile of our portfolio doesn’t significantly change, and we can capture a tax benefit made possible by downward price movement in the market.
Sell Concentrated Positions
If any stock makes up more than 10% of our total portfolio, we have a concentrated position. Putting so many eggs in one basket increases the risk level of our portfolio. The easy solution is to sell some of this stock and diversify into other investments but there may be constraints that make that difficult. For example, selling the concentrated position might result in large capital gains and significant taxes.
Down markets are an opportunity to revisit concentrated positions and determine if changes to the stock’s price have made selling it more attractive. If lower values also translate to lower capital gains, we may be able to sell some or all of the stock and reinvest the proceeds into a more diversified mix of investments.
Consider a Roth Conversion
A Roth conversion is when we move cash or investments from an IRA into a Roth IRA. Once the money is inside the Roth IRA, future growth occurs tax-free if you follow a few basic rules. In most cases, the amount moved out of the IRA into the Roth will be counted as income and taxable in the year of the conversion.
As an example, let’s say we move 100 shares of ABC stock valued at $20 per share from an IRA to a Roth. The taxable amount is $2,000 (100 shares x $20). Whether the price of ABC increases to $30 or $3,000, once the money is in the Roth IRA, the growth won’t be taxable as income even when you take money out of the account.
Doing a Roth conversion when investment values are down can allow us to move more money into the Roth at a lower tax cost. If ABC stock was trading at $20 but falls to $15, we can move the same 100 shares to a Roth while only incurring $1,500 of taxable income. If ABC stock recovers in price, the shares are already inside the Roth where any future appreciation is tax-free.
If we can see ourselves as life-long investors, we can view downturns as what they are: moments of opportunity. When investments aren’t providing us with an immediate return, we can still find ways to benefit whether it be reducing risk, maximizing tax benefits, or optimizing our investments for future growth.
As originally published on Forbes: https://www.forbes.com/sites/danielleseurkamp/2022/04/27/make-negative-returns-a-positive-for-your-portfolio/?sh=d8823d91853a