KEY TAKEAWAYS
- Remain calm and do not panic during periods of market declines and crashes, they are normal part of the investing market and happen frequently.
- Stay the course and follow your investment policy statement or plan allocations.
- Actions to NOT do include: panicking, selling or changing positions, and changing investment strategies.
- Other actions to consider doing: tax loss harvesting and Roth conversions.
Okay, first I need to apologize for the click bait-y title. What we are in right now might feel like a crash to a few new investors, but this is not a “crash,” at least not technically but we are getting close. Generally, a crash or a “bear market” is defined as a market correction of 20% or more. As of this writing, May 22nd, the S&P500 is down 19%, classifying it as a “correction.”
And the current decline is nowhere near the Dotcom bust of the early 2000s when the market was down 34% or the Great Recession of 2008 when the markets were down 49%. I am excluding the Corona Crash of 2020 because that decline was so short many investors didn’t even have time to process it. The decline started in February 2020 and the market was already heading back up by March 31, so investors receiving only quarterly statements might not have even noticed it.
The current downturn has the makings of lasting longer than the Corona Crash, so it is getting a lot more attention. Inflation is high, forcing the Federal Reserve to increase interest rates to control it but this action has historically caused businesses and individuals to rein in spending, which in turn creates the conditions for a recession. BUT, since the Fed has been telegraphing these moves over a long period of time there is hope a recession may be avoided.
But if anyone tells you they know definitely what will happen, run away. Those are the predictions of snake oil salesmen. The predictions of even the brightest people in the economic and financial industry have been wrong too many times to count.
So, we’re in a correction not a depression—and we have no idea what is going to happen. Great. Now what should we do?
Step 1: DO NOT PANIC! Stop, reflect, listen to the soothing words of JL Collins. Are you calm yet? If not, keep repeating Step 1 until calm. Once you’re calm, let’s examine the options, starting with what not to do.
What Not to Do
Do not sell everything and go to cash: We have previously documented the problems with holding cash, namely inflation. What you would be doing by going to cash is engaging in market timing – trying to get in and out of the market at the right times. This strategy has been proven time and time again as not working. Here, here, here, here, here…
Change investment theories: This is a close cousin to the first item, but here the investor is rationalizing a drastic move to another portfolio construction while acknowledging holding cash is a bad idea. It will usually include a rationalization like, “well this time is different, with this new information moving to a portfolio of xyz is more prudent.” It may sound very smart, but it usually means selling an asset at its low (i.e., stocks now) and moving into a “smarter” asset (i.e., commodities). The issue is that the “smarter” asset is usually something that is currently popular and is already priced high. You’d be selling low and buying high. Bad idea. More retirement plans are undone by changing investment theories at the bottom than by any other mistake. I don’t know how to be clearer than this: DO NOT CHANGE INVESTMENT THEORIES DURING TIMES OF MARKET UNCERTAINTY.
What to Do
Stay the course: If you have a written investment policy statement, now would be a good time to read it. Were you following it before the market correction? If it includes a plan to rebalance (it should), wait until it’s time to rebalance and then follow through with the rebalance plan. If it’s not time, then don’t rush into rebalancing now. The plan was set up in better times and hopefully reflects your more rational, calm self. If you are hell bent on changing investment plans, I would suggest some extensive research into what your new plan might be. Might I recommend Next Level Finance’s videos on different portfolio theories and investing? With almost 200 videos at 10 to 20 minutes each, hopefully once you have watched them all, the market will have begun to recover.
If you are still in the accumulation phase of your financial life, your plan should include continuing to invest. That should be continued. Most commonly this is through 401K or other retirement plan contributions withheld from your paycheck. Continuing to buy a fixed amount while the market increases and decreases is commonly referred to as dollar cost averaging, buying more shares when the cost is cheap and less as the prices go up. This is a great way to naturally buy more shares when the prices are low and less when they are high.
Tax loss harvesting: At its core, tax loss harvesting turns investment losses into tax breaks. It works best for investors in individual stocks (because they have more losses!). But even for index investors, if you have recently opened new positions which are now below your purchase price, those positions could be sold to lock in the loss and make it tax deductible. The loss can be used to offset gains, or, if no gains exist, up to $3,000 can be used to offset ordinary income (if any amount remains, it can be rolled into future years). In the 24% tax bracket with no other gains, a $3,000 loss will save you $720 on taxes. Then you can buy a similar but NOT identical position in another fund and retain your investment exposure. For example, if you sold the Vanguard Large Cap ETF, you could buy the Fidelity Large Cap ETF. They are similar, but they contain different underlying positions. If you buy identical funds, you may become subject to wash sale rules so make sure you understand them before you attempt tax loss harvesting.
Roth Conversions: If investing income is a significant proportion of your total income, as it may be in early retirement, your reportable income could be lower in 2022 than in prior or future years. The sliver lining is it may also present an opportunity for additional Roth conversions, converting more shares at a lower value with less tax impact than when the market was at all-time highs. Roth conversions can be complicated but if your 2022 income is lower due to market returns, it is worth exploring.
Recoveries and Reassurance
But you’ve heard all these stories about staying the course before, right? Those are just words, you say. You need Data!
No one know the future, but here are some reassuring stats from previous corrections:
- Market corrections of 15%, happen about once every 3.5 years, 10% corrections happen about every year, and 20% drops or more happen every 6.3 years. Corrections and rashes are normal and just part of the investment cycle.
- Corrections between 10 and 20% have happened 27 times since 1946, with the average being 13%. The average length of time between peak and trough was four months, but the average time to recover was only three months!
- Even more surprising (even to me) is that the price return (nominal index value excluding dividends) in years with a correction (10–20%) is positive 70% of the time. But if you go to cash, you have a 100% chance of locking in your losses now. Sign me up for the 70% chance of full market recovery, please!
There is an old investing adage about “time in the market beats timing the market.” Try to ignore short-term market movement and focus on dollar cost averaging into the markets whenever you have the funds to invest.
Lastly, I leave you with amazing statistic: in the 20 years between 1996 and 2015, the average annual return on the S&P 500 was 8.2%. But if you tried to time the market during that period and missed the 10 best days (out of a possible 7,300 days), your annual returns would have dropped from 8.2% to 4.5%! Sounds pretty easy to mess up applying that market timing idea.
If you have any thoughts or opinions about this, please email me or leave a comment below.
Until next time, spend less than you make, invest the difference in low-cost index funds, be kind to your neighbors, and you will succeed in reaching your financial goals and in making the world around you a happier place.