You are probably aware that August was an eventful month for stocks – in a bad way. The S&P 500 was down 6.03% bringing year to date returns to -2.88%. A diversified portfolio would have cushioned against the drop somewhat, but allocations to Emerging Markets and Commodities hurt returns. The monthly numbers aren’t even the scary part. Volatility shot through the roof on the 24th as the markets opened dramatically lower and spent the rest of the week rebounding and dropping multiple times. The best and worst trading days of the year so far both occurred that week.
The consensus view is that the steep market drop in China triggered the sell-off as well as concern over the Federal Reserve possibly raising rates in September. The 24th looks like it may have experienced a mini flash-crash where computerized trading algorithms possibly drove market prices sharply lower. Maybe everyone left their computers in charge while they were away in the Hamptons?
We finally got the correction that everyone and their brother has been calling for with this 12% drop. Here is where I am supposed to trot out the old talking points – take the long-term view, turn off CNBC, stay invested. I should also make a folksy observation – this is my five year old son’s third market correction. Maybe I should throw in a statistic that looks meaningful and puts this back on a serious track – the average calendar year actually sees a drawdown of 14%. Finally, there should be an appeal to stay the course and don’t try to time the markets.
Seriously? Staying the course is boring. When the market is down, we feel like we have to do something. Isn’t there some sort of action to take in times like these? Yes, there are opportunities to take advantage of during a down market that shouldn’t disrupt a sound long-term financial plan. One opportunity is to rebalance, which is wise regardless of the market climate, but another only presents itself when things turn sour – tax loss harvesting.
Investors buy securities with the expectation that they will increase in value. An increase in price is unrealized until the investor sells the security (at which point they become realized gains). If the price went up, the investor gets taxed on the difference between the sales and purchase price, or capital gain. So what happens if the price goes down? The investor can sell the security and realize the loss. Our instinct, however, is to do nothing and wait until the price eventually rebounds. Why would you want to lock in a loss when you expect the investment to eventually recover? Through careful tax loss harvesting, there is an opportunity to both save taxes and still participate in the eventual recovery.
For example, let’s say an investor recently bought $100,000 worth of an emerging markets stock fund that has since fallen in value to $90,000. That investor could do nothing and wait for that $90,000 position to eventually get back to $100,000 and beyond. However, a better answer may be to sell that fund and realize the $10,000 capital loss. That $10,000 capital loss will likely result in a guaranteed current or future tax savings of up to $3,000. Meanwhile, the investor can then take the $90,000 from the sale and just buy a different emerging markets fund. Moving forward, the investor still has the same $90,000 invested in emerging markets. The “old’ fund and the “new” fund won’t perform exactly the same. One may do slightly better or worse than the other, but by selling the “old” fund and buying a “new” fund (and thus realizing the loss) the investor also saves up to $3,000 in taxes.
There are all sorts of additional rules regarding wash sales, long-term vs short-term, and other things that make accountants squeal with delight, but that’s the basic idea behind tax-loss harvesting. The really fun part of this is in applying this across a diversified portfolio. As one asset class goes up, another asset class is probably going down. An investor could realize the loss in a lagging asset to be used against a gain realized from rebalancing. They have saved themselves from having to spend real money on taxes due to paper gains. The volatility of the markets is now working for them, allowing them to reduce their future tax bill while also keeping a larger amount of money working in the markets for longer. Down markets can feel stressful, but it’s an opportunity to allow another piece of the financial plan work.