No one likes watching their investments go down. Hard-earned money and previous gains seemingly evaporate over a few days, weeks, or months. Companies and assets you felt great about owning, you now wonder if they’re worth holding on to at all.
Everything is easy when markets are going up. But the psychological effect of losing money is the hardest part about investing.
You’re used to being in control of things. Now your net worth is spiraling downward.
Your logical brain is telling you, “Relax. Everything will be fine in the coming months and years. You have prepared for this. You’re investing for the long-term, and this is a normal part of market cycles.”
But your emotional brain is screaming, “This is an emergency! Run! Fight! Do something!”
Most people give in to their emotions. They sell their investments and hold on to “safer” cash until the bloodbath is over. This leads to greater drops in the market than the economic situation called for.
Those same people now have to deal with the other side of the coin. When do they buy back in? Most of the time, the market recovers so quickly that they miss out on the upside and buy in at a higher price than they sold!
Don’t let this be you.
Most often, the best thing you can do during market turmoil is to look away. Ignore financial media. Ignore friends and coworkers who are predicting doom and gloom. And do nothing with your investments.
But if you’re like me, you are too interested in this stuff. You can’t just sit on the sidelines. You need to take some sort of positive action.
What can you do that might help you capitalize on this situation, but won’t interfere with your portfolio and your overall investment strategy?
Here are 5 great moves to consider when your investments are down big.
1 Tax loss harvest
Tax loss harvesting should be on your mind if the following applies to you:
- You have a taxable brokerage account
- The funds it holds are down more than 10% from purchase price
- Your taxable income puts you in a significant tax bracket this year
As I wrote in Put Your Retirement Savings in These Accounts First, tax loss harvesting occurs when you sell an investment at a loss in order to reduce your tax burden for the year. The loss first offsets other capital gains. Then it reduces your ordinary income, which is taxed at a higher rate. The limit on ordinary income offset is $3,000, and anything beyond that is carried over into a future year.
Many people wait until the end of the year to do tax loss harvesting. At that point, they know their income and tax situation with more certainty. But the full advantage could be missed if the market recovers by then. And there is a 30 day period before you can do it again. So you will still have time for a final round of harvesting this year as long as the last time was before November 30th.
You don’t just want to sell your losers when they are down, however. The point is to capture the tax loss while maintaining your desired asset allocation. To do this, you can buy a similar—but not “substantially identical”—investment with the proceeds of the sale.
For instance, you might buy a total stock market fund to replace the S&P 500 index fund that you sold. These two indexes have almost identical performance and 99% correlation, but the IRS would not consider them identical, and will allow you to claim your tax loss.
This article describes the rules of tax loss harvesting in more detail.
Here is an example of some tax loss harvesting that I did myself:
I harvested $10,841 in losses this way.
This will amount to a tax savings of $1,836, assuming that I have $7,841 of long-term capital gains to offset at 15% and can claim $3,000 of this loss against ordinary income in the 22% tax bracket. The next table shows this breakdown.
Of course, when these investments eventually recover and I sell the shares, I will have a larger tax gain to deal with now. That’s where tax gain harvesting comes into play. My plan is to take those gains in years when I am in a lower tax bracket.
I discussed tax gain harvesting in Put Your Retirement Savings in These Accounts First.
2 Rebalance
Well-diversified portfolios tend to shift out of balance after large swings in the market. This might be a good time for you to check the balance of assets in your portfolio.
You should rebalance if:
- any of your large positions are 5% or more off their target percentage or
- any of your small positions (5% or less of overall portfolio) are 1% or more off their target percentage.
In a non-taxable account, rebalancing is easy and there are no tax considerations. Sell some shares of positions that are too high and use the proceeds to buy the positions that are lower than target.
In a taxable account, you need to take taxes into consideration as you rebalance. This is easier in a down market since there are usually losers that can be sold to balance out any winners while you are rebalancing. Tax loss harvesting can be done at the same time as you rebalance, in other words.
The most tax efficient approach to rebalancing a taxable account, when tax loss harvesting is not an option, is to use dividends from the position that is too high to buy more of the position that is lower.
This takes longer and can’t be done all at once, however. And some funds and stocks do not have dividends, so it isn’t always an option. But you may realize that you are automatically reinvesting dividends and shouldn’t be. It is tax inefficient to reinvest dividends in a fund that you will need to sell more of soon.
Another good option that works for both taxable and non-taxable accounts is to add money to the under-balanced position. Then nothing needs to be sold. This only works if you are in the accumulation phase, of course. It doesn’t work if you are on the Descent, drawing income from those accounts.
3 Find better funds
The next move goes well with tax loss harvesting and rebalancing. Find funds with lower expenses and better composition.
You can change funds easily inside tax-advantaged accounts. The only penalty might be the bid/ask spread on the trades.
In taxable accounts, however, you have to be careful about the tax consequences. So make sure you aren’t creating a big, unnecessary tax bill in the process of switching funds. Buy them when you are tax loss or tax gain harvesting, rebalancing, reinvesting dividends, or investing new cash. You could be doing more harm than good otherwise.
3.1 Lower expenses
Fund managers cover their overhead and get paid by taking fees from every dollar that you invest in their fund. These fees take the form of an “expense ratio”, which you can find in the fund’s prospectus or by typing the ticker symbol into a fund research tool such this one from Fidelity or this one from Financial Times.
There are many types of expenses that might show up in a fund’s expense ratio. Some mutual funds also carry fees called “loads”. The industry has been regulated now to the point that fees are much more transparent, and it’s easy to stay away from loads on funds. So I will not go into detail on the types of fees.
The surest way to improve your investment returns is to use the lowest cost fund for each asset category that you are investing in.
This should be your guideline: avoid loaded funds entirely and look for funds with expense ratios of 0.15% or less.
There is huge competition between companies like Schwab, Vanguard, iShares, and Fidelity to provide the lowest fees in each asset class. So these funds should not be too difficult to find.
Fees create a drag on your investment returns. A 0.1% improvement in annual expenses may not sound like much. But over 30 years in an investment compounding at 10% per year, you would add another 47% of your initial investment for every 0.1% in expense savings!
3.2 Better composition
Expenses are not the only thing that makes a good fund, of course. Every fund you own needs to do a good job of tracking its underlying index, meet its stated investment objectives, and align with your objectives for that piece of your portfolio.
A good example is if you are looking for exposure to small cap value companies. Not all small cap value funds are created equal.
Take a look at these two Vanguard funds: VBR and VIOV. Both are considered Small Cap Value funds. Yet 42% of VBR holdings are mid-cap companies, defined as having a market value between $2 and $10 billion! VIOV holds almost no mid-cap. Instead, 46% of its holdings are in micro-cap companies with market values less than $250 million.
As a result of this weighting, VIOV will be more uncorrelated with large-cap funds than VBR. I used Portfolio Visualizer to run them against Vanguard’s S&P 500 fund, VOO, and found that VIOV is 5% less correlated to the S&P 500 than VBR.
Which one do you think I should pick if I want small company exposure and diversification in my stock holdings?
What if I told you that VIOV has a 0.15% expense ratio and VBR’s is only 0.07%? This is where it becomes a judgment call. But I am willing to pay 0.08% to get the asset allocation that I am looking for in this case.
Table 5 shows that VIOV has beat VBR by 0.38% annually since 2010. So the extra expense has paid for itself during that period, at least.
4 Do a Roth conversion
Another great move when your investments are down is to convert money from tax-deferred retirement accounts—traditional 401k, IRA, 403b, or 529—into a Roth IRA.
I wrote in detail about Roth conversions in Secrets to Getting Money Out of Your Retirement Accounts Early. In this article, I will use an example to demonstrate why Roth conversions make sense when asset values are lower.
The advantage in doing a conversion when the market is down is that you can convert a larger number of shares without pushing into a higher tax bracket. This can potentially avoid larger taxes in the future when those shares are worth much more money.
This strategy works best for people who have:
- a relatively low income this year and
- a large expected tax-deferred account balance in retirement.
If you are still earning income and haven’t contributed the max to your Roth IRA or Roth 401k yet, you should be doing that before worrying about a Roth conversion. Read Put Your Retirement Savings in These Accounts First for more on Roths, including backdoor and mega backdoor Roth contributions.
Table 6 gives an example where your shares are converted from your 401k to a Roth IRA at two different times. When they are converted now, the share price is $50. Your income is low this year, so the $50,000 conversion falls within the 12% tax bracket.
Now let’s say that you decided against a conversion this year. Instead, you withdraw those shares from your 401k when the share price has doubled to $100. You could be converting them to a Roth IRA or using them as retirement income in this case.
You now owe taxes on $100,000 instead of $50,000 in the previous case. It wouldn’t matter whether you pull the money out now or later if it was taxed at the same 12% rate,. But it’s harder to fit $100k into the same bracket that $50k fit in before. So let’s assume that you effectively pay 22% on it now.
After you pay the $22k in taxes, you are left with $78k. If you had converted earlier your Roth would have grown to $88k. You are much better off converting to a Roth IRA now if this is the scenario that you anticipate!
5 Find extra cash to deploy
There is no better time to increase your savings rate than when the market is down. Go make some more income or save money in some area of your life! Your future self will thank you.
I showed in My Investments Keep Going Down. Now What? what happened during the Great Recession of 2007-2008 “if you invested [an extra] $100/month for one year from the point the market was down 20%. Ten years after the first monthly investment, your $1,200 grew an average of 230% to $3,962.” This happened even though the market continued going down. It was still down 20% by late 2011 after counting for inflation!
Any extra money that you can invest when your investments are down will multiply in the long-term.
So start picking up overtime. Start that side hustle that you’ve been dreaming about. Sell some stuff that you’ll never use again. Go out to eat a few times less per month. There is always a way to increase your savings if you are motivated.
Summary
Emotion runs high when your investments are declining. It’s easy to give in to fear, doubt, and panic. This causes us to sell at the worst times and miss the biggest market gains.
One way we can control our emotions—rather than letting them control us—is to take action.
This article presented 5 great actions you can take when your investments are down:
- Tax loss harvest
- Rebalance your portfolio
- Find better funds to shift into
- Perform a Roth conversion
- Find extra cash to invest
Focus on one or more of these positive actions instead of the negative emotions and the destructive actions that they may lead to. You will feel better and more optimistic when you do. And you will be setting yourself up for financial success when the market eventually recovers.
Are your emotions taking over your better judgment?
What action do you need to take today to keep your emotions in check and investments on track?
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