The stock market is on pace for its worst December since the Great Depression
— CNBC, December 17, 2018
A bear market still lurks despite this week’s stock rally on the Dow
— USA Today, December 28, 2018
Markets poised to finish year with worst performance in a decade — and the volatility seems certain to continue
— The Washington Post, December 29, 2018
The financial press must have enjoyed the stock market sell-off at the end of 2018. The actual headlines above are just a few I noted which were designed to capture the reader’s attention. The media even posted comments from former Federal Reserve Chairman, Alan Greenspan who was quoted saying the bull market was over. Why Mr. Greenspan’s stock market predications were newsworthy is a mystery to me. Any investor who listened to Mr. Greenspan’s irrational exuberance warning about the stock market in 1996 would have missed the next three years of the bull market that decade.
I’m not trying to say that stock market sell offs are a good thing. No one enjoys seeing their stock portfolio shrink in value. However, when investors take a step back and view the stock market over a long period of time, we observe that bear markets are a natural occurrence in the never-ending market cycle. Over the past 70 years, there have been 12 bear markets1. Counting the two 19.4% dips in 1998 and 2011, which technically weren’t bear markets because they were not down 20% (close enough by my reasoning), that averages one bear market about every five years. A bear market was overdue.
Opportunities when a Bear Market Occurs
The bear market is not the problem. What can be observed by reviewing these 14 bears markets is that the market has recovered from every one of them and went on to make new highs. It is a waste of time to beat yourself up because you didn’t recognize the “signs” of the coming bear market. No one can consistently predict short-term movements in the market. The good news is you don’t have to be able to predict the markets movement to a successful investor. In fact, legendary investor Peter Lynch said, “The key to making money in stocks is not to get scared out of them.”
The stock market sell-off at the end of 2018 was actually very fortuitous for investors who view the drop as temporary. Consider the opportunities the temporary drop in value creates:
Tax loss harvesting
No one expects to lose money on an investment, but the reality is that a bear market can drop the value of recent investments below the purchase price. A stock investment of $100,000 could drop to $80,000 during a bear market. This decline is considered an unrealized loss if the investor continues to hold it. Unrealized losses have no tax benefits. Selling the investment for $80,000 creates a loss of $20,000 that can be used to offset other realized gains. Only $3,000 can be used in any one year to offset other types of income. Any loss in excess of $3,000 can be carried to the next tax year and used to offset gains until the loss is used up.
You should approach tax-loss harvesting cautiously. It is easy to get lost in tax implications and lose sight of your overall financial goals. You should always begin with your investment strategy in mind and harvest losses where an investment change could enhance your portfolio as well as your tax situation. The first priority should always be investment performance. Don’t let taxes get in the way of making smart investment decisions.
Bear markets can be a great time to convert some of an IRA account to a Roth for long term investors holding stocks and stock funds in their retirement accounts. Investors must pay taxes on IRA withdrawals someday; what better time than when the market is down? This strategy calls for some advance tax planning to calculate the tax implications of a conversion. The advantage of a Roth conversion comes when the market recovers, and the account grows back to its original value. The account growth from the recovery will be all tax-free! (At least it will be, once you hold the funds for five years or have reached age 59 ½).
Lower required minimum distributions (RMD)
A person turning age 70 ½ must begin taking distributions from their IRA by April 1st of the year following the year they turn age 70 ½. The amount of the RMD is calculated by taking the account balance on December 31st of the prior year and dividing it by the life expectancy of the account owner. The stock market sell-off at the end of 2018 will mean lower RMD amounts for senior investors who held stock or stock funds in their IRAs.
Rebalance your portfolio
Investors allocating between stocks and bonds will most likely have too much money in fixed investments during a bear market. For example, an investor with an allocation of 60% stocks and 40% bonds may find their stock allocation is only 50-55% after a bear market. They could rebalance by selling some of their bonds to buy stocks while the market is low and bring the allocation back to 60/40. Following this strategy will help the portfolio recover faster when stock prices recover.
Assisting with your investment strategy is a small part of what our financial advisers can do for you. Learn how we can help you create an investment strategy that aligns with your retirement goals.
- Tax loss harvesting should only be done when it also has the potential to enhance the portfolio.
- Bear markets have occurred every five years on average since the end of World War II.
- Investors should monitor their balance between stocks and bonds to take advantage of big moves in the market.
1 Stock Market Retreats and Recoveries, by Sam Stovall, American Association of Individual Investors.