Another week, another rough ride in global stock markets as we all digest unfolding events around the coronavirus and oil prices.
While we shared some of our general thoughts on the events and our philosophy on how markets work, a common question asked is – what do we do at this time? What actions are we taking with our portfolios? What decisions should be made around our investments?
Here are few opportunities, decisions, and actions we’re considering for client (and our own) portfolios:
1. RebalancingThis is a key action we’re looking to take.
What is rebalancing? This is selling the categories of investments that are higher than you want to hold, and buying the categories that are lower.
When we build client portfolios, we diversify across different investment categories. There are the main categories – stocks, real estate, and bonds. Within those, there are also subcategories – large and small companies, value vs. growth, US vs. foreign, etc. We target a certain percentage to hold for each category.
However, over time the rise and fall in each investment type drifts away from the intended target percentage. This can be sudden, during dramatic market swings (up or down) as we’re seeing now. Or, it can be gradual.
When we rebalance, we simply sell the category that’s higher than we want to hold (for example, bonds) and use those proceeds to buy the categories that are too low (for example, stocks).
Why do this? This is a systematic way to sell high and buy low. It doesn’t feel intuitive at the time – buying the categories that are experiencing a bear market. However, long-term it can provide a great benefit to your portfolio and keeps it within the risk profile you originally wanted.
2. Tax-Loss HarvestingLosses never feel good, but there is a silver lining!
What is tax-loss harvesting? Selling positions that are at a loss and buying shares of another fund to replace it (this does not apply to retirement accounts).
When you sell positions for a loss, it’s a tax deduction that can be used to offset other capital gains you’ve triggered this year. Up to $3000 can also be used on your Tax Return to offset ordinary income. And you can roll any unused losses to be used in future tax years. For those with large enough losses, with large capital gains, or at a high enough tax bracket, this can be a great opportunity to take advantage of the decline in prices.
However, the second step here is very important. This is not selling out of the position and staying in cash. It’s immediately buying another similar investment. You want to stay invested.
There are some risks and rules to follow here, so it’s important to do this with caution. First, when harvesting (selling) stock positions, you are out of the market for a day even if you immediately buy another stock investment. It simply takes time to do the transaction.
Secondly, you have to be careful not to buy the same investment you sold within 30 calendar days (or one “substantially identical”). Even in a different account, such as a retirement account. The IRS has “wash-sale” rules that would disallow the loss you created if not followed correctly.
3. Continued Deposits and ContributionsFor investors with long-term time horizons, this decline in prices means everything’s on sale. We aim to continue all regular, ongoing deposits and contributions and invest accordingly. What a great buying opportunity!
4. Process for Portfolio WithdrawalsFor those that are withdrawing from their portfolios, we use the following process to manage the portfolio and create cash for withdrawals:
• Have a cash buffer: We aim to have 3 months-worth of withdrawals in a cash buffer for very short-term needs. This is in addition to cash savings account clients may have at the bank.
• Selling from categories that are high and allowing the others to recover: We aim to not sell the investments that have gone down in value during a market decline. In this case, that’s stocks. In fact, selling stock positions converts a temporary decline into a permanent loss.
We are able to rely on the bond portion of the portfolio to sell if needed. Bonds are historically a great diversifier and an important anchor of stability. While stocks have tumbled during this decline, high-quality bonds have largely been positive (as of writing).
So, we trim bonds to send funds to clients, allowing stocks to recover.
• Take advantage of portfolio income. As your portfolio distributes interest income or dividends, those chunks of income are either reinvesting (at more favorable, lower prices) or creating cash as needed.
• Not making material changes to our portfolios or process. We don’t know what’s next for stock prices or for the economy. But, as Evon mentioned in his recent post, this is a normal part of stock/business ownership. As earnings are expected to decline and uncertainty increases, the prices of stocks to decline. These short-term declines are the price we pay for higher long-term expected returns. We expect this as a part of our long-term investment philosophy and process.
So, barring major life changes, we aren’t planning any major changes to our investment allocations. We take advantage of opportunities mentioned above, and stay the course. Our long-term outlook is one of positivity – this too shall pass!
PS: Our preferred Mutual Fund provider – Dimensional Fund Advisors – is offering a webinar tomorrow (Friday the 13th) entitled Perspective on Recent Market Volatility. Watch your email for instructions to attend.
The Pathways Team
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