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Worried About the Markets? Have a Plan

How can you make a plan to limit emotional decisions during market lows?

By Patrick Kuster, CFP

It’s no secret that for most people it hurts to see investment balances go down through periods of market decline. With the pain of seeing a falling balance on portfolio statements comes the potential desire to act. Having a process that leaves out the emotion can be a helpful guide when balances go down and emotions are at their peak.

Patrick Kuster

Patrick Kuster

While there are many such processes to consider regardless of whether markets are at all-time highs or lows, evaluate the following strategies as key reminders during market lows.

Rebalancing

We can’t control investment markets and trying to predict the optimal time to buy and sell generally leads to suboptimal long-term results. Defining an asset allocation, such as what percentage of a portfolio should be in equities, e.g., stocks, alternatives, e.g., real estate and commodities, and fixed income, e.g., bonds, is the first step in determining whether a portfolio owns too much or too little of an asset class. From here, decisions can be made to further outline how much of the equity allocation should be to U.S.-based stocks versus international, or other more granular allocation decisions that are meant to stay consistent. Getting out of dollar terms and into percentages can help us confirm if we should consider selling some of one asset class to purchase another as market cycles shift.

It is through rebalancing that we can resist the urge to sell equities when markets are down – in fact, rebalancing when equity values are down would generally lead to buying more. This is also to say that having a rebalancing process in your investment approach would mean selling when equity values have exceeded allocation targets.

An example of such a process would be to say that a portfolio is to target a specific amount in equities (say, 60%), and that if equities diverge 5 percentage points from that target, the portfolio will be rebalanced (so if the portfolio exceeds 65% in equities some would be sold and if the portfolio drops below 55% in equities some would be purchased). Others consider a rebalancing process around specific timing, such as quarterly, but this may miss large short-term swings.

Tax-Loss Harvesting

For non-retirement accounts, Uncle Sam doesn’t know that your investments are up or down until you sell. The goal of tax loss harvesting is to generate a tax loss when investment values are down to offset future gains. As this strategy is essentially a tax deferral, it is especially beneficial when losses are generated at higher tax rates and offset by future gains at lower tax rates. Simply put, if you expect to stay at a similar tax rate in the future or anticipate that your rate will go down, selling investment losses may generate a long-term benefit.

With that said, there are specific rules to consider when coupling rebalancing procedures with tax-loss harvesting opportunities. For instance, it is generally the case that if things are down, your rebalancing procedure may be queuing you to buy more of an asset rather than selling it at a loss. Specifically, to avoid wash sales when selling in down markets to harvest losses, you may seek to purchase back a similar (same asset class) but different (not substantially identical) investment. An example would be selling an S&P 500 ETF and buying back a large-cap, actively traded mutual fund.

In terms of rules, a process may be something like, “If an investment decreases by more than 5% AND incurs at least $5,000 in losses, then the position will be tax-loss harvested.”


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Location Optimization

In line with rebalancing is choosing where to own which investments. Putting this differently, rules surrounding rebalancing reflect how much of each asset class we should own, whereas location optimization is the choice of which accounts we purchase the investments within. It’s generally optimal to prioritize tax-inefficient investments in tax-deferred accounts.

This is to say that investments that produce dividends at ordinary income-tax rates, such as income produced by bonds, are generally best prioritized to traditional IRAs or pre-tax retirement plan accounts, leaving most tax-efficient investments to non-deferred accounts, such as an individual brokerage account. Keep in mind that you need to consider how investment location impacts after-tax investment risk, which is to say that owning the same dollar amount of an investment within a traditional IRA does not carry the same amount of after-tax risk as owning it within a Roth IRA or non-retirement account.

Ultimately, location optimization is about knowing how to prioritize which investments go to which accounts, primarily weighting after-tax expected returns, and understanding its implications when rebalancing. Specific to down markets, this means evaluating whether there is an opportunity to swap highest-expected-return, tax-efficient investments from tax-inefficient accounts such as a traditional IRA or non-qualified deferred annuity to a non-retirement brokerage account or Roth IRA. An example would be selling bonds in a brokerage account to buy equities and selling the same dollar amount of equities in a traditional IRA to buy bonds.

Pay careful attention to wash sale rules and understand that sales for a loss within a non-retirement account can still potentially trigger wash sales when purchased back in other accounts. An example would be selling a particular investment for a loss within a non-retirement brokerage account and immediately buying it back within an IRA. In this example, the loss would trigger a wash sale, effectively eliminating the tax loss, and, now that it’s owned within an IRA, no loss would ever be captured.

Roth Conversions

Is part of your plan to execute Roth conversions? For those who are already considering a Roth conversion, converting “in-kind” (transferring shares from a traditional IRA directly to a Roth IRA or from a traditional 401(k) to a Roth 401(k)) during a down market may be optimal. Adding location optimization to the mix, if an investment would ultimately be prioritized to a Roth IRA and that investment’s value is down, it may be the right time to consider moving it over.

Many investors set their annual target for Roth conversions in terms of dollars surrounding tax brackets or Modified Adjusted Gross Income amounts. When share prices decrease, that means more shares can be transferred to meet the Roth conversion dollar amount target. This means moving investments over when they’re down and hoping to see them recover within the Roth IRA.

In terms of setting rules, it may make sense to know the minimum amount you can convert within a year and “true-up” at the end of the year when there is more clarity to exactly where taxes will settle. This consideration usually occurs in unison with an investment-loss trigger. As an example, the rule might be, “If small-cap stock prices drop by 20% before converting this year, it’s time to convert $40,000 worth of shares.”

Evaluate Goals

Revisiting your financial goals during down markets is important. During your review, you may find you are still on track even with market downturns, or you may find that you need to adjust some goals, such as spending less on travel during this time. If your goals include gifting to loved ones, especially for estate tax purposes, gifting investments that have decreased in value with expected appreciation on the horizon means being able to gift more shares.

It’s also important to reflect on how you are feeling. Too often investors believe they are capable of stomaching more losses than they have an appetite for. Downturns might not be the right time to make an emotional decision to sell or adjust your long-term portfolio allocations, but you may want to take that feeling into account in the future when evaluating if reducing the risk in your portfolio is prudent.

Impact

Whether markets are at their peak or going through a crash, having a process is critical to helping you avoid adverse decisions and take advantage of financial planning opportunities. Market downturns are inevitable, and, as the saying goes, “failing to plan is planning to fail.”

About the author: Patrick Kuster, CFP®

As a Wealth Advisor with Buckingham Strategic Wealth, Patrick Kuster, CFP®, AIF®, knows that even the most thorough and well-conceived financial life plan is only as good as its implementation. He works closely with clients to help them solve their financial puzzle – pulling apart plans, rebuilding them, then seeing them through – and achieve their most important retirement goals.

Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting, legal, or tax advice. Individuals should speak with qualified professionals based upon their individual circumstances. The analysis contained in this article may be based upon third-party information and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, confirmed the accuracy or determined the adequacy of this article. IRN-21-2776


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Email Jeffrey Levine, CPA/PFS, chief planning officer at Buckingham Wealth Partners, at: AskTheHammer@BuckinghamGroup.com.