Economic uncertainty and market volatility in the current environment are reminders of the importance of establishing a disciplined investment strategy that you can stay committed to in challenging times. Recessions are a normal part of the economic cycle and periodic market volatility is to be expected. Holistic planning and regular monitoring of plans can help investors find comfort and clarity in periods of stress, as well as opportunity. Here are seven planning items and strategies to consider in the current environment.
1. Review asset allocation and consider opportunities for strategic rebalancing
One of the primary drivers of portfolio performance is asset allocation, and a critical step when building a portfolio is establishing the desired level of risk you want in your portfolio. Once an appropriate investment allocation is chosen, monitoring it over time is important, particularly as the market moves.
In down markets, being proactive and trimming assets that have held more of their value and rebalancing into others that have experienced a drop in market price may present an opportunity. Buying into the market at lower and more attractive entry points allows for greater potential future appreciation and the ability to recover portfolio losses more quickly when out-of-favor investments eventually rebound.
When considering whether to rebalance your portfolio, investors should set reasonable ranges around asset class and sub asset class allocation targets to establish when rebalancing thresholds have been met. It may feel counterintuitive to trim investments that are holding steady or increasing in value to add to those that have underperformed, but the “sell high, buy low” philosophy is one that can help you strategically use volatility to your advantage.
2. Execute tax-loss harvesting transactions
An opportunity often overlooked during market downturns is harvesting capital losses in taxable brokerage accounts. While market declines never feel good, selling investments held at a loss can create considerable tax savings in the current year and potentially in the future as well.
Tax-loss harvesting is a strategy in which investors sell holdings that have depreciated below their cost basis, booking (or “harvesting”) those capital losses to offset realized capital gains. Current year realized capital gains are offset first, while excess capital losses can offset up to $3,000 of ordinary income and then the remaining losses will carry forward to offset what could otherwise be taxable capital gains in future years. When engaging in tax-loss harvesting, investors must pay close attention to wash-sale rules that prohibit proceeds from being reinvested in the same or substantially identical securities within 30 days. A failure to do so would negate the ability to claim the loss on your income tax return.
Booking tax losses can be beneficial, but it’s critical that such transactions don’t result in material changes to one’s portfolio or asset allocation. As such, we recommend that any positions sold be replaced by a comparable strategy that allows the investor to maintain exposure to the corresponding asset class or style. It’s important to develop a comprehensive plan and given the tax nuances involved in executing it properly, we recommended that you consult with professionals when considering tax-loss harvesting strategies.
3. Consider a Roth IRA conversion
Roth IRAs are attractive retirement savings vehicles because of the potential for tax-free growth and income — advantages that can make Roth IRA conversions a worthwhile consideration. Such conversions are often taxable events but converting traditional IRA assets to Roth IRAs now can be an effective strategy to hedge against the potential for higher tax rates in the future. Several different strategies should be considered, as well as rules and pitfalls to avoid surrounding these conversions, however, when portfolio values have been reduced due to market conditions, Roth conversions can present a compelling opportunity. A further market decline is always a risk but converting investments that have fallen in value could provide greater potential for tax-free growth in the future when the market recovers.
Consulting with professionals is advised, but if you self-manage investments and/or prepare your own tax returns, be sure to fully understand the considerations and consequences before moving forward with a Roth IRA conversion.
4. Consider interest-bearing investments for emergency funds and cash reserves
An important piece of financial planning, particularly during times of volatility, is carefully evaluating the adequacy of your emergency fund and cash reserves. A general guide is to have at least three to six months’ worth of fixed and discretionary expenses set aside in reserve. There is always a chance you could experience a loss of income or incur unexpected expenses. Of course, you may prefer to have a larger cash reserve, particularly given the volatility in the financial markets over the past 18 months. A little extra cash can be comforting and reduce the potential of needing to tap your investment portfolio for cash at an inopportune time.
Now that yields on CDs, savings, and money market accounts have increased, there may be additional opportunities to increase your cash reserves and get a nice return without the risk of loss from market volatility. Conversely, if you’ve been accumulating excess cash, market volatility can create a good opportunity to invest it when values have been reduced.
5. Put excess cash to work in risk assets
One of the hardest times to separate emotion from objective fact in investing is when you’re faced with deciding whether to invest a large sum of money into the markets during a period of market volatility or economic uncertainty. Fear of investment losses can lead to decision paralysis and the trap of market timing. Moreover, if the market continues to rise, it can become even harder to put that capital to work.
Countless studies have shown the difficulty of accurate market timing. If an investor is willing to accept the risk, research indicates that probabilities strongly favor lump-sum investing as the optimal strategy for investing cash in a long-term portfolio. The likelihood of positive returns increases as one’s time horizon is extended, so investors looking to put cash to work in their portfolios for the long term could view the current environment as an attractive buying opportunity.
If you’re nervous about investing a lump sum of cash or are hesitant to enter the market, implementing a dollar cost averaging (DCA) strategy may be an appropriate alternative. DCA strategies call for a lump sum of cash to be divided into predetermined amounts that are then invested at prescribed intervals until the full sum is invested according to your long-term asset allocation targets. DCA strategies can underperform lump-sum investing in the short term if prices rise, but if you’re concerned with investing in the current environment, DCA strategies can reduce the risk of emotional decision-making and help you put cash to work in a disciplined manner.
6. Make tactical asset allocation adjustments
A long-term disciplined approach to investing is a proven, time-honored method to prepare for retirement and other financial goals. Although sticking with a given risk level and avoiding panic selling or market timing during periods of volatility is prudent, market dislocations can at times create opportunities that may warrant minor shifts to your investment policy at the margins. These shifts wouldn’t necessarily come in the form of changing the strategic balance between stocks and bonds, but rather be in the form of tweaks to the underlying allocations within those asset classes.
For example, during a market downturn, international stocks may have sold off more than U.S. stocks, creating a valuation disparity that could justify adjusting the target allocations between the two sub asset classes without changing your total allocation to equities. Increasing your portfolio’s relative allocation to a dislocated asset class can further enhance the portfolio’s return potential. These are the types of opportunities you and your advisors should consider when market volatility or significant disparity in the relative returns occur.
7. Evaluate opportunities to reduce the cost of debt
Monitoring debt balances and having a plan to tackle them is a pillar of successful long-term financial planning. Economic downturns are a great time to revisit these plans because interest rate movements typically accompany market volatility.
Mortgage rates have risen in the past year; however, rates can change quickly. If the economy softens and rates fall, borrowers may have an attractive opportunity to refinance the debt, particularly with mortgages originated in the past year or so. A general rule of thumb to refinancing is that interest rate savings should be at least 0.75%. Also, pay close attention to closing costs to ensure interest rate savings aren’t eroded.
Interest paid on variable rate debt also rose considerably during the past year. It could be appropriate to aggressively pay down debt with higher variable rates, such as credit cards and home equity lines of credit, particularly if that interest isn’t tax deductible. The benefit from eliminating debt with variable rates could be even more pronounced if interest rates continue to rise. Doing so would likely take precedence overpaying down fixed rate debt with lower interest. There is always market risk, but it’s worthwhile to consider opportunity cost and the potential for your investment rates of return that exceed the interest rates associated with fixed rate loans. Today’s cash yields may easily surpass fixed interest rates on loans originated before the Fed’s recent tightening cycle.
While the current environment has certainly been challenging, a sound investment strategy with appropriate risk management can provide peace of mind. Routine monitoring with a disciplined approach can help investors take advantage of opportunities during periods of economic uncertainty and market volatility and remain on track to meet financial goals.
