When stocks are down, many articles come out trying to calm people down. They typically say “don’t sell” or “do nothing.” Here’s a recent one from James Osborne at Bason Asset:
Here’s what you should probably do when stocks go down: nothing. Boring advice, I know. But usually you should do nothing. Sometimes there’s an opportunity to take some tax losses. Sometimes it will warrant rebalancing (though rarely upon a 10% correction, depending on your rebalancing rules). Most of the time you’re going to do nothing. We’re not good at doing nothing (more on that later) but give it a try. Go outside or read a good book and tell yourself “This Is What Stocks Do,” and do nothing.
In addition to doing nothing, it mentioned two actions you can take sometimes: tax loss harvesting and rebalancing. Let’s take a look at each one. Are they better than literally doing nothing? If you have a psychological budget to do only one of the two, which one should you do?
Tax Loss Harvesting
Tax loss harvesting refers to realizing some losses for tax purpose. You sell low, but you put the proceeds into a similar fund. The tax loss you realize can be used to offset your realized capital gains, if any. If your realized losses are greater than your realized gains, you can offset up to $3,000 of your income. If you still have more losses, the unused losses can be banked and carried over to next year. They don’t expire until you die.
Because you are not taxed in tax advantaged accounts such as 401k or IRA, tax loss harvesting only applies if you have a regular taxable account. Because only recent purchases before the market drop have losses, your selling and generating losses is limited to those recent purchases.
I have shares I bought in 2011 in my taxable account. Even though they lost value in the recent downturn, they are still worth 50% more than my cost. Chances are slim that I will ever be able to do tax loss harvesting on those shares.
Most people have more money in tax advantaged accounts than in taxable accounts. If you have been investing for some time, your recent purchases make up only a small percentage of your account. Suppose 30% of your portfolio is in taxable accounts. Suppose your recent purchases make up 10% of that. After a 10% market correction, you have 30% * 10% * 10% = 0.3% of your portfolio in losses. Say harvesting that 0.3% in losses will save you 15% of the losses in taxes. Performing tax loss harvesting will then save you 0.3% * 15% = 0.045% of your portfolio in taxes. In finance lingo, you will have a one-time tax saving worth 4.5 basis points of your portfolio.
Over time, your recent purchases will make up less and less of your total portfolio. As a result, the benefits from tax loss harvesting as a percentage of your portfolio will become smaller and smaller.
Rebalancing refers to shifting your investments to realign your ratio of stocks and bonds to your original asset allocation. After a drop in the stock market, it usually means selling bonds and buying stocks.
Rebalancing can be performed in both tax advantaged accounts and taxable accounts. It’s actually better done in tax advantaged accounts because there are no tax consequences there.
Let’s also run a back-of-the-envelope example.
Suppose you start with $100k, $70k in stocks and $30k in bonds. After stocks drop 10%, suppose bonds are flat, you now have $63k in stocks and still $30k in bonds. If you rebalance back to 70% in stocks, you will sell $30k – $93k * 30% = $2,100 from bonds and buy $2,100 in stocks. After rebalancing, now you have $65,100 in stocks and $27,900 in bonds, still $93k total.
When stocks eventually recover to the same level as before, suppose bonds are still flat, you will have 65,100 / 0.9 = $72,333 in stocks and $27,900 in bonds, for a total of $100,233. If you literally did nothing the entire time, you will be back at $100k. The extra $233 if you rebalanced came from buying $2,100 in stocks when stocks were 10% lower.
The benefits from rebalancing is 0.23%, or 23 basis points, of your portfolio. It’s not much but it’s several times larger than the tax saving from tax loss harvesting. Because rebalancing isn’t limited to taxable accounts or recent purchases, its benefits do not decay over time.
If stocks continue dropping beyond the 10% correction, rebalancing at a later time may produce a higher gain when stocks recover. Still, as long as stocks beat bonds on its way to recovery, rebalancing when stocks are lower will always be better than literally doing nothing.
Nothing holds you from doing both at the same time. Sell your shares that have a loss and buy a similar but different fund. Sell some from bonds and put the money into stocks. Either is better than literally doing nothing. You stack the benefits if you do both.
If psychologically you can only handle doing one of the two, then I would prioritize rebalancing over tax loss harvesting. Tax loss harvesting feels clever as you are beating the tax man, but rebalancing is much more powerful.
I created a one-question poll to see what you did in the recent downturn. Please take 10 seconds to answer it. You can also see what others did in that poll.
Say No To Management Fees
If an advisor is charging you a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice: Find Advice-Only.