As you can imagine we have had a lot of conversations with our investment management clients over the past few months. Most of these conversations have two main themes: (1) have your objectives and risk tolerance changed and (2) losses, while not welcome, provide an opportunity.
The first theme is a cornerstone of long-term investing. Most investment advisors will require their clients to complete a risk-tolerance questionnaire. These take many different forms and ask a variety of different questions across the multitude of assessments; however, the result is the same – a determination of how much risk is the client willing to take. The risk assessment then forms the basis of the portfolio the investment advisor creates for the clients.
Almost all portfolios will take losses when the broader market falls 20% or more. It is important to understand unless there is a material change in the client’s situation (e.g. layoff, unexpected passing of a family member or major medical expense, etc.) or their tolerance for risk has substantially changed then stay the course. Do not sell your portfolio and hold cash thinking you will get in on the recovery. For example, after a 20% market decline, on average, the broad market was up 14.2% after one year and 11.8% after five years.
A J.P. Morgan analysis found an investor with $10,000 in the S&P 500 Index who stayed fully invested between Jan. 4, 1999 and Dec. 31, 2018 would have made approximately $30,000. If that same investor got out of the market and each year missed 10 of the best days would have under $15,000. If he was a very skittish investor and missed 30 of the best days he would have approximately $6,200 less than what he started with.
However, this does not mean you cannot make some tactical changes within your portfolio. Despite the bear market many portfolios still have significant gains after the long bull market. Also, people who receive equity compensation (Incentive Stock Options, Restricted Stock Units etc.) may have sizable paper gains and are reluctant to sell because of significant capital gains taxes. Also, your portfolio may have some poorly performing stocks that are down significantly from when they were first purchased. Now is the time to execute a strategy called tax-loss harvesting.
Tax-loss harvesting is a strategy whereby investments that are at a loss (the current market price is below the initial purchase price) are sold creating capital losses. These losses can be long term or short term depending if you held the position for longer than one year. Capital losses can then be used to offset both long and short term capital gains.
In the example of a portfolio with capital gains, the investor can now recognize those gains and offset them with the capital losses. Those funds can now be redeployed in a more defensive posture or can be invested in a new stock position that is currently oversold and will rebound strongly once the market begins its recovery.
For those people with significant gains in their employer equity compensation, and potentially a high concentration of their employer’s stock, they can now sell their shares and use their capital losses to offset their gains. They can now take the resulting cash and invest in a risk appropriate diversified portfolio.
The final option is to just “bank” your capital losses. There is no limit to the number of years you can carry forward your capital losses. They do not expire. Also, capital losses that exceed capital gains in a year may be used to offset ordinary taxable income up to $3,000 in any one tax year.
We must note there is a “wash-sale” rule to be aware of. An investor is dis-allowed the capital loss if they repurchase the same or similar stock within 30 days of the initial sale which created the capital loss. If you are considering this type of strategy, we strongly encourage you to speak with your investment and/or tax professional for advice on your particular situation.
Daniel T. Goodman CLU®, CFP®
Director of Financial Planning, Sierra Pacific Financial Advisors, LLC