For many people, it’s easy to dismiss the advice that you should “just sit tight” during periods of market volatility. No matter how normal these periods are, it doesn’t take away from the very real emotions people feel when seeing their portfolio values decline. The experience often triggers your “fight or flight” instincts and a feeling that you should be doing something. And although the best course of action (assuming your goals and objectives have not changed) is typically to stay the course, there are some things you can do to capitalize on market volatility.
At the outset of the financial planning process, you should have an investment plan, which contains a specific target asset allocation based on your goals and objectives. In simple terms, your investment plan should specify how much to have in stocks versus bonds and U.S. versus international investments.
The day after you implement your plan, the value of your investments will change. If you have a diversified portfolio, some of your investment assets will go up while others may go down. This is exactly what you want to happen. A gap between your current investment allocation and the target allocation in your investment plan will inevitably develop as certain investments perform better than others.
During volatile market environments, there can be a large performance discrepancy between asset classes (stocks versus bonds) and between sub-asset classes (U.S. versus international). This often presents the opportunity to rebalance your portfolio by selling some of what has outperformed and buying some of what has underperformed. We view this process as buying more of what is temporarily on sale, and if done in a disciplined manner, you are effectively “buying low and selling high.”
This process of buying what is “on sale” feels much more intuitive outside of investing. For example, our wives love shopping at Trader Joe’s and often purchase greeting cards, which are always $1. If there was ever a 20% sale on those cards, our wives’ first reaction wouldn’t be to second guess if the price will go lower or if the quality has declined. Rather, they would look to buy more, likely many more, before the price returns to $1. With investing, the thought process should be the same. When the market declines temporarily, you should take advantage of the sale. You do this by remaining disciplined with rebalancing.
Market declines present the opportunity to revisit taxable investment accounts and identify securities that could be sold to lock in a loss for tax purposes. If you have capital losses greater than capital gains, you can deduct up to $3,000 of those net losses annually from ordinary income on your tax return. Since the tax deduction comes from ordinary income, the value of the benefit increases as income rises, and at the highest marginal tax bracket, this provides a nice tax planning opportunity.
An additional benefit of tax-loss harvesting is that you can carry forward any losses that exceed $3,000 to future years. This allows you to “harvest” excess losses during market corrections and subsequently recognize the benefit in future years when your portfolio has capital gains.
Revisit Goals and Objectives
While revisiting the key elements of your financial plan should be an ongoing process (at least annually), market declines often bring your financial plan into clearer focus and present a good opportunity to revisit assumptions. In investing, it makes sense to take risk proportionate to what is required to achieve your goals. If your portfolio is tracking well ahead of what is necessary to meet your goals, and you find yourself averse to the feelings that accompany market drawdowns, it might make sense to step back and reaffirm whether your asset allocation still aligns with what is required to achieve your goals and objectives. In investing, it’s okay to stop playing the game once you’ve won.
What NOT to Do
The biggest thing to avoid during times of market volatility is making an emotional, knee-jerk decision based on a short-term perspective and present feelings, without looking at things in perspective. Wholesale changes to investment policy and allocation should not be made in response to market movements. Such changes should only be made if your underlying goals and objectives have changed.
While almost nobody enjoys the feeling of market volatility, as an investor, you can do more than just stand by passively. By proactively looking for opportunities to rebalance your portfolio, tax-loss harvest, and reassess your goals and objectives, you can make the most of a challenging situation. And while these action items may not fully qualify as making lemonade from the lemons of market volatility, at the very least they can make those lemons taste slightly less bitter.
About MD Wealth Management: We are an Ann Arbor financial planner that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.