When the market is down, it hurts to look at your portfolio and see your account values dropping. And when we experience pain, we feel the need to do something. Unfortunately, the knee-jerk reaction to sell everything almost always ends up being the wrong move, a fact which although obvious in hindsight, is nevertheless a very tempting idea when we feel panicked.
Even when we know that market cycles are an inevitable part of being a long-term investor, it is still frustrating to just sit there and not do anything when we have a drop. What should you do when the market is down? Most of the time, the best answer is to do nothing. However, if you are looking for ways to capitalize on the current downturn, here are five things you can do today.
1) Put cash to work. The market is on sale, so if you have cash on the sidelines, I wouldn’t hesitate to make some purchases. Stick with high quality, low-cost ETFs or mutual funds, and avoid taking a flyer on individual stocks. If you’ve been waiting to fund your IRA contributions for 2015 or 2016, do it now. Continue to dollar cost average in your 401k or other automatic investment account.
2) If you are fully invested, rebalance now; sell some of your fixed income and use the proceeds to buy more stocks to get back to your target asset allocation. Of course, most investors who do it themselves don’t have a target allocation, which is their first mistake. If you don’t have a pre-determined asset allocation, now is a good time to diversify.
3) Harvest losses. In your taxable account, look for positions with losses and exchange those for a different ETF in the same category. For example, if you have a loss on a small cap mutual fund, you could sell it to harvest the loss, and immediately replace it with a different small cap ETF or fund.
By doing an immediate swap, you maintain your overall allocation and remain invested for any subsequent rally. The loss you generate can be used to offset any capital gains distributions that may occur later in the year. If the realized losses exceed your gains for the year, you can apply $3,000 of the losses against ordinary income, and the remaining unused losses will carry forward to future years indefinitely. My favorite thing about harvesting losses: being able to use long-term losses (taxed at 15%) to offset short-term gains (taxed as ordinary income, which could be as high as 43.4%).
4) Trade your under-performing, high expense mutual funds for a low cost ETF. This is a great time to clean up your portfolio. I often see individual investors who have 8, 10, or more different mutual funds, but when we look at them, they’re all US large cap funds. That’s not diversification, that’s being a fund collector! While you are getting rid of the dogs in your portfolio, make sure you are going into a truly diversified, global allocation.
5) Roth Conversion. If positions in your IRA are down significantly, and you plan to hold on to them, consider converting those assets to a Roth IRA. That means paying tax on the conversion amount today, but once in the Roth, all future growth and distributions will be tax-free. For example, if you had $10,000 invested in a stock, and it has dropped to $6,000, you could convert the IRA position to a Roth, pay taxes on the $6,000, and then it will be in a tax-free account.
Before making a Roth Conversion, talk with your financial planner and CPA to make sure you understand all the tax ramifications that will apply to your individual situation. I am not necessarily recommending everyone do a Roth Conversion, but if you want to do one, the best time is when the market is down.
What many investors say to me is that they don’t want to do anything right now, because if they hold on, those positions might come back. If they don’t sell, the loss isn’t real. This is a cognitive trap, called “loss aversion”. Investors are much more willing to sell stocks that have a gain than stocks that are at a loss. And unfortunately, this mindset can prevent investors from efficiently managing their assets.
Hopefully, now, you will realize that there are ways to help your portfolio when the market is down, through putting cash to work, rebalancing, harvesting losses for tax purposes, upgrading your funds to low-cost ETFs, or doing a Roth Conversion. Remember that market volatility creates opportunities. It may be painful to see losses today, but experiencing the ups and downs of the market cycle is an inevitable part of being a long-term investor.
