A glimpse at the bear market playbook
The stock market has shown remarkable strength since its recent low, though it is still down 15 percent from the all-time high set on February 19. Given the ongoing COVID-19 threat, many people wonder if the market will go lower. Personally, I don’t worry about it. Bear markets happen and we work through them. And even in bear markets there are opportunities to build wealth if you know where to look for them.
In this week’s column I thought I would give you a glimpse into my “bear market playbook.” Here are six strategies you can use to make the most of a bad stock market.
Strategy #1 – Avoid market timing. Some people try to sell out of their investments during a bear market because they feel they can’t afford to take large losses. Unfortunately, by the time they decide to sell, the damage has already been done and selling just makes it worse. If you can’t stomach market volatility, look at your portfolio allocation before the bear market begins. Make sure you have the right equity exposure for all market conditions.
Strategy #2 – Dollar cost averaging. Bear markets are a great time to buy stocks and dollar cost averaging is a great way to do it. With dollar cost averaging you commit to invest a certain dollar amount at a pre-determined frequency, usually weekly or monthly. As the market drops, your fixed dollar investment will buy more and more shares at cheaper prices. Just make sure you are averaging into a diversified portfolio of high-quality stocks. An index mutual fund is a great dollar-cost averaging vehicle.
Strategy #3 – Tax-loss harvesting. Tax-loss harvesting involves selling an investment at a loss while simultaneously buying an investment with similar characteristics. Tax-loss harvesting allows you enjoy the tax benefits of the loss without reducing your exposure to the market. The tax losses you realize can be used to offset future capital gains and up to $3,000 of taxable income each year. Take care that the security you buy is not “substantially identical” to the security you sell otherwise it will result in what is called a “wash sale” and you will not get the benefit of the tax loss.
Strategy #4 – Roth conversions. Since a bear market would temporarily reduce the value of your traditional IRA, it would also reduce the tax burden associated with doing a Roth conversion. This strategy might be especially attractive to someone who would normally be taking a required minimum distribution this year. Since the CARES Act suspended RMDs for 2020, such an investor could convert what they normally would have taken as an RMD without any increase in their taxable income. Whether this would make sense for you depends on a number of factors, so consult with your advisor before taking action.
Strategy #5 – Clean out the dead wood. Over time portfolios can grow stale. Investments that were once successful may not keep up with their peers. Investors may need to shift their asset allocation. Whatever the reason, most portfolios should be updated from time to time. During a bear market, these changes are easier to make since lower asset prices reduce capital gains and lower tax consequences.
Strategy #6 – Hedging. Hedging is the process of using gains in one asset to offset losses in another. Hedging is expensive and constructing and managing an effective hedge is complicated. However, there are products available that might make a hedged portfolio more accessible to you. For example, several fund companies offer hedged equity funds that provide some downside protection while maintaining some exposure to the stock market. Talk with your advisor to see if hedging makes sense for you.
By the way, if you want to see a great talk that puts our current situation in historical context, take a look at Warren Buffett’s remarks at his annual shareholder meeting this past weekend. He makes a strong case to invest in America. You can find his remarks on YouTube.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to: firstname.lastname@example.org