Descriptions of the long-term behavior of the stock market can seem a lot like shampoo instructions: the market goes up, followed by a drop, then it goes back up again. Wash, rinse, repeat.
Market declines are unpleasant but must be accepted as part of the trade-off of long-term investing. Regrettably, the investment media feeds into our base fear of how to minimize the impact of market downturns, typically immediately after one occurs. Unfortunately, most of this coverage advises actions that are not usually prudent for long-term investors. They are looking to appeal to the human desire to “control” such events.
Market timing “sages” with elaborate technical strategies that purport to tell you not only when to sell but also when to buy back in often get the most media attention. History has shown that these strategies are very difficult to successfully implement on a consistent basis. Jumping in and out of the markets usually does more harm than good to investors with long-term time horizons.
Rather than using market timing as the tool to try to dodge market declines, consider the following prudent strategies to better prepare yourself to handle market downturns.
1. Set aside cash that you know you’ll be using in the next 6 to 12 months.
When your portfolio starts to drop, it’s nice to know that you don’t need to immediately take funds out of your accounts. Everyone’s cash set-aside amount will be different. If you’re working, it’s dependent on the stability of your job and whether you have other income streams. If you’re retired, your pensions and Social Security income will factor into your decision. There’s also personal preference involved – every household is going to have a cash buffer that they’re most comfortable with.
2. Rebalance your portfolio.
If you’re using a reputable financial advisor, this should already be happening. You very likely have a target asset allocation, and market movements may make your current portfolio not look like your target. While rebalancing can’t prevent market declines, it does result in buying assets at relatively lower prices. When stocks go down, fixed income assets will often hold their own or even appreciate, so rebalancing allows investors to sell assets that have appreciated on a relative basis and buy assets that have decreased on a relative basis – a sound strategy for long term investment success.
3. Save a little extra and/or spend a little less.
Some of this is human nature; we often adjust our spending behavior based on the increasing or decreasing value of our portfolio. If you’re still working, try to increase your savings and investment rate a little bit since you will be buying into stocks at lower prices. If you’re retired, try to slightly lessen your portfolio draws as a way to partially mitigate the impact of market declines.
4. Reinvest your dividends.
Not only does this give you some additional return on your investments to help offset market declines, but in a declining market your reinvested dividends are buying securities at relatively lower prices.
5. Make use of tax loss harvesting strategies.
If you have after-tax accounts, tax loss harvesting allows you to sell securities that have decreased in value, book the loss for tax purposes, and then buy back a similar but not identical security. It’s a great way to stay invested while also generating some capital losses, which can be used to offset capital gains. If you have more losses than gains, you can use up to $3,000 of the excess losses to offset ordinary income. If you still have losses after that, you can carry them forward into the next tax year, and the whole process starts over.
6. Consider re-evaluating your investment risk tolerance
A market decline is almost never the time to change your portfolio, and generally we don’t want to change our portfolios based on recent market events. In other words, we don’t want to all of sudden “become” a conservative investor if the market is dropping and we don’t want to switch to being an aggressive investor because the markets are soaring higher.
Market declines can, however, be a good time to take a step back and re-examine your investment risk tolerance. While “risk” has many meanings, most of the time investment risk tolerance is a measure of how comfortable you are with market volatility. Work with your financial advisor to determine an appropriate investment mix that considers both quantitative and qualitative measures of risk to determine a portfolio that’s right for you.
These are simple and sensible strategies to implement before and during a market decline to hopefully make things a little more comfortable. The focus is more on preparation, logic and the future, and less on panic, emotion, and current events.