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A sharp market decline can be terrifying, especially if you’re approaching or in retirement. But even a bear market can present opportunities for investors. Here are 10 possibilities.


“Panic is not an investment strategy,” says Liz Ann Sonders, Chief Investment Strategist, Charles Schwab & Co., Inc.

A falling stock market can be terrifying, especially if you are nearing, or in, retirement. It is critically important to not overreact and allow the emotion of fear to result in moves that could harm long-term goals and objectives. Selling at or near the bottom can also permanently alter future rates of return for the portfolio. It may feel good temporarily, but it can cause poor results for the future.

The past is past (even if it is the very recent past), and we should all be looking toward the future. Any downturn is temporary, not permanent, and it should be viewed through that lens.

So what can an investor do in the midst of trying times? We will look at several potential moves one can make; that is, ten tactics, from the simple to the more advanced. All ten are not for everyone, but one or more may apply to almost everyone. Competent legal, tax, and financial advice should be consulted prior to utilizing any of these tactics

10 Tactics to Consider During Market Declines

1) Buy! Invest excess cash. And, if eligible, contribute to a Traditional or Roth IRA.

“Keep some dry powder” is one of those tried-and-true Wall Street adages. It means to always have some cash on the sidelines, and when an opportunity presents itself, an investor has the cash to capitalize on that opportunity.

“Buy low and sell high” is another well-known phrase. When the bear market or correction occurs, it is the proper time to invest and buy stocks. It is not the time to sell stocks. It is also a good time to consider contributing to and investing in an IRA, whether deductible or not. There are income limitations, as most people are aware, but if eligible, it makes good sense to contribute to an IRA during a market decline and invest for the long term.

2)  Realize capital gains on legacy stocks or mutual funds and reinvest into an evidence-based/scientific asset allocation

2a) Get out of high expense mutual funds. Not all mutual funds are created equal. Much has been written over the past decade regarding the high internal fees of many mutual funds. This issue has been a primary focus in the U.S. Department of Labor with regard to retirement accounts.

If a high expense mutual fund has been held for many years, selling it could create a large capital gain. While its performance may be lagging due to the high fees, a person may be reluctant to sell and realize those gains. A market pullback presents the opportunity to sell at a lower tax hit and reinvest in a more cost-effective mutual fund within an evidence-based asset allocation strategy.

2b) Reduce or eliminate single stock risk. No one thought General Motors would go bankrupt (or Lehman Brothers, or Toys R Us, or Sears, or Enron, or Eastern Airlines). But they did. Stockholders lost their entire investment. Owning individual stocks presents a tremendous level of risk. This risk can easily be diversified away.

An investor should be very careful in designing a liquidation strategy, and this could be accomplished all at once, or over several years. A down market is an opportune time to accelerate that strategy and reinvest the proceeds into more diversified investments at a time when prices are down.

3) Harvest losses

Any time the market sells off, it is a good time to examine each holding within the portfolio. If any of the positions have an unrealized loss, that position should be sold in order to realize the loss for tax purposes. Then, the proceeds are immediately reinvested in a similar, but not identical, asset. Fiduciary investment advisors do this as a normal part of their investment monitoring process.

However, individual investors find this emotionally difficult to do. In fact, many investors don’t want to sell when an investment is up because they’ll have to pay capital gains taxes. And they don’t want to sell when it is down because it might mean admitting they made a mistake, and they’d rather wait for it to go back up to prove themselves correct. This is flawed thinking.

A scientific asset allocation has specific target percentages for different types of stock, bond, and alternative investments. There should be a primary and a secondary fund for each asset and sub-asset class in the portfolio. The fiduciary advisor simply sells the primary fund which is at a temporary unrealized loss and on the same day purchases the secondary fund in the same asset class. This harvests the loss for tax purposes, but maintains the asset allocation. This is important because during a down market, no one knows which day is “the bottom” until months later, looking back.

The capital losses can then be used to offset up to $3,000 of current income as well as current/future capital gains.

4) Execute a Roth Conversion

A Roth conversion from a Traditional deductible IRA is a taxable event. Generally, Roth conversions make sense if the person expects to be in a higher tax bracket later in life, when Roth IRA withdrawals would be tax-free. In other words, pay taxes now at a lower rate and withdraw later tax-free in a higher tax rate environment.

Tax laws require a careful estimate of the tax impact of a Roth conversion. And for those on Medicare, be aware that the higher MAGI (modified adjusted gross income) resulting from a Roth conversion could cause a senior to pay higher Medicare Part B premiums. Just one dollar over the threshold amount of MAGI limitation will result in higher premiums.

If it makes sense to do a Roth Conversion (and it does not make sense for everyone), the best time to do it is when the stock market has tumbled. Because qualified Roth IRA withdrawals are totally tax-free for both growth and contributions, it is wise to put the most aggressive (highest growth potential) investments of an overall allocation into the Roth. When the market goes back up, these more aggressive investments should appreciate even greater than the general stock market.

5) Take RMDs (Required Minimum Distributions) from bonds in IRAs; invest after-tax proceeds in stocks (if not needed for living expenses)

Retirees who must withdraw a certain amount from their IRAs each year can either spend that money or reinvest in an after-tax account. For spending, when the stock market is down, the RMD should be taken by selling bonds to raise the cash for the withdrawal. Remember, buy low and sell high.

If the plan is to reinvest, it makes sense to take the RMD when stock prices are depressed and immediately re-invest in stocks or stock funds in the after-tax account at low prices. The person can effectively remove more shares at lower prices from the IRA, pay the requisite taxes, and then invest for the eventual recovery in value.

Keep in mind that the SECURE Act, passed in late 2019, changes the required beginning date to age 72 for anyone who had not already turned 70-1/2 in 2019 or earlier.

6) Rebalance portfolios

Again, this is easy for professionals and difficult for individual investors. This is due to individual investors’ emotions and behavioral psychology. Simply put, within the asset allocation of stocks, bonds, and alternatives, when one category has dropped in value versus its target and other categories have risen in value, sell the “winner” and buy the “loser.” That is emotionally counter-intuitive because most investors want to hang on to their winners and get rid of their losers (or, as stated above, wait for them to come back).

Rebalancing is a mechanical, non-emotional way to sell high and buy low. Most people know that is the way to make money, but it is not easy to actually do it. Rebalancing has been shown to both reduce risk and help improve returns over time.

Vanguard, the mutual fund company, estimates that the value of rebalancing by professional advisors adds about 0.35% to the average client’s investing experience. (“Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, March 2014, The Vanguard Group, Inc.)

Liz Ann Sonders, of Charles Schwab and Company, says “This is the closest thing to a free lunch for investors.”

7) Liquidate a Deferred Annuity and reposition into a tax-efficient account

Most fiduciary advisors do not recommend clients invest in variable deferred annuities. This is because internal fees are very high, significant surrender charges (early withdrawal penalties) are a problem, and growth in value—while tax-deferred—eventually is taxed as ordinary income instead of the more favorable capital gains rates. Also, annuities do not enjoy stepped up basis after death as capital assets (real estate, stocks, mutual funds, etc.) do. This means that the heirs must pay income taxes on growth after the annuity is transferred to them. For capital assets with stepped up basis, it is possible to pay zero capital gains taxes on inherited funds and property.

When someone realizes that investing in an annuity was a mistake, the problem is then how to get out of it. There is often a 10% free withdrawal amount each year that is not subject to surrender charges, so a slow liquidation (which also spreads out the tax hit) is often recommended.

But once the surrender charge period is over, selling the entire annuity could create a large tax liability. Thus, a market decline presents an opportunity to liquidate while prices are down and the taxable gain is lower. It is often a good time to sell out of the annuity and reinvest in lower cost, more tax-efficient investment vehicles that enjoy both lower capital gains rates during lifetime and stepped up basis after death.

8) Leverage gifting to family members utilizing annual gift exclusion (including 529 plans)

Most people are aware they can gift up to $15,000 per person per year; this is known as the annual gift exclusion. This amount also functions as the upper threshold for funding 529 plans for the future college education of children or grandchildren (although five years’ worth of gifting can be front-loaded).

What better time to gift or buy stocks and stock mutual funds than during a stock market correction or bear market? If an investment has dropped in value from, say, $18,000 to $15,000, it could be gifted at that time. When the market recovers, the person has leveraged the gift—effectively gifting an investment worth more than the temporary lower value at the time of the market drop. Funding a 529 plan at a market low accomplishes the same thing—buying when prices are low so that the value after the market rebound is greater than the amount of the gift.

9) Transfer assets to an Irrevocable Trust

Another estate planning technique is to transfer a house, stocks, or other appreciating assets into an irrevocable trust. There is no estate tax advantage for the transfer itself, but again, the benefit is that when prices rise after the transfer, all that appreciation value is outside of the estate of the person making the transfer.

Estate planning professionals call this an “estate freeze,” as the value of the asset being transferred is frozen as of the date of the transfer. All subsequent growth will not be part of the taxable estate.

10) Create and fund a GRAT (Grantor Retained Annuity Trust)

A GRAT is an advanced estate planning tool for people with a taxable gross estate (greater than $11.58 million per person for 2020), especially for those who live in a state with a state estate tax and a low exemption amount. Without going into great detail, an investor funds a GRAT with stock or stock mutual funds and gets paid back from the GRAT the entire amount, plus interest.

The interest rate is based on the published Internal Revenue Code (I.R.C.) §7520 rate, currently about 1.8% (March 2020). If the appreciation on the asset donated to the GRAT exceeds 1.8%, then all of the excess appreciation goes to the heirs. Better yet, there is no taxable gift and the excess appreciation is not subject to estate taxes.

The GRAT term can be two years, five years, 10 years or more. At the end of the term, the amount left in the GRAT goes to the heirs designated in the document.

Thus, when the market declines and stock prices are temporarily low, it presents a tremendous opportunity to benefit from the eventual recovery.

Conclusion

All ten of the strategies above have similar themes. These include the estate freeze, the leveraged gift, or the concept of selling bad investments and buying good investments at low prices. In addition, tax considerations are an important part of these ideas.

If market declines were permanent, none of this would be good advice. However, since throughout history stock markets around the world have shown tremendous resilience and a persistent upward trajectory, it is a valid assumption to believe that good businesses will do whatever it takes to optimize profits. Stock prices and company profits are related (the “price-earnings” or “P/E” ratio). Thus, as profits improve, stock prices also generally move up.

The primary way to protect a portfolio from steep declines is by means of the asset allocation. The number one decision in asset allocation is the percentage allocated to bonds. When the stock market goes down, bonds don’t just “sit there”; they often actually go up in value. Why? Because institutional investors sell stocks, and with the proceeds they buy bonds, which causes the prices of bonds to rise.

An excellent illustration of this principle at work is seen in what happened from the peak of the stock market in October 2007 through the bottom in March 2009, and subsequent years. A portfolio invested 100% in the S&P 500 Index lost 55% from peak to trough, and it took three years to get back to even.

Alternatively, a 60/40 portfolio (60% stocks/40% bonds) only lost 25%, and took 18 months to recover. Finally a 40/60 portfolio lost only 15% and was back to even in just eight months. (J.P. Morgan “Guide to the Markets”, 1Q 2020, page 64)

Of course, in subsequent years the S&P 500 Index significantly out-performed both a 60/40 and a 40/60. But this example illustrates how important it is to get the asset allocation right, according to an investor’s investment objectives, and their tolerance for market declines.


This is intended for informational purposes only and should not be construed as personalized investment, tax, or financial advice. Please consult your investment, tax, and financial professionals regarding your unique situation.

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