Making the most of a bad market

Steve Merrell |

In case you hadn’t noticed, the stock market has been under a little pressure lately. The S&P 500 index has fallen 10% from its all-time high on September 21. The tech-heavy NASDAQ index has been hit even harder, dropping 15% from its high on August 29.

The market’s sharp drop has raised the anxiety level for some investors. I have had several people ask me if this is the start of a bear market. I always tell them the same thing: I don’t know. Nobody does. The pundits who try to tell you otherwise are simply fooling themselves.

I recommend investors ignore the pundits and focus instead on building strong portfolios suited to their particular goals. Instead of watching the pundits, watch your portfolio. If you keep your eyes open and your fears at bay, you will be surprised how many opportunities a little market pressure can open up to you. A simple case study can help illustrate what I mean.

Let’s suppose you have a friend who won’t stop talking about all the money he is making in tech stocks. Finally on July 9, after weeks of non-stop badgering, you finally break down and buy shares of Netflix. You call up your broker and tell her that you want to buy $5,000 worth of Netflix, an order she dutifully executes. At the end of the day she calls to tell you that you are the proud owner of 12 shares of Netflix at $416 per share.

Unfortunately, the Netflix earnings report is a little disappointing and in the weeks following your purchase, the price of a share of Netflix slides from $416 to $267. Your 12 shares of Netflix are now worth only $3,204 leaving you with an unrealized loss of nearly $1,800. What do you do?

Before we go any further, you need to understand that nothing you do now will undo the fact that you have a loss in your Netflix position. However, you have several options that could help turn the decline in Netflix into something that could benefit you going forward.

For example, if you have done your homework and really like Netflix stock and feel strongly that the price is going to recover, you could use the market downturn to purchase additional shares. This is called buying on weakness and it can be an effective way to build a core position in an investment you really like.

If your stock is in a taxable portfolio, you can sell the Netflix shares and realize the capital loss. The tax code says that individuals can accumulate capital losses indefinitely and use them to offset future capital gains. You can also use $3,000 of capital losses to offset ordinary income in any given year. In other words, the capital loss has value to you from a tax point of view. Recognizing a capital loss and using it to offset future tax obligations is called tax-loss harvesting. You can invest the proceeds in another asset, including a mutual fund or index ETF. If you really want to keep Netflix in your portfolio you can purchase it again after the 30-day wash sale requirement is met.

Finally, if you have the loss in a traditional IRA, you can use the down market to convert the Netflix shares into a Roth IRA. By doing a transfer-in-kind from your traditional IRA to a Roth you can do the conversion without having to sell the shares first. By moving the Netflix shares into the Roth, you put yourself in the position to benefit tax-free in the stock’s recovery.

Applying these strategies to your specific circumstances may require additional modifications. If you have questions about any of these strategies, you should discuss them with your financial advisor.

 

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey.   He welcomes questions 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 smerrell@montereypw.com.