Poking the Bear: Use the Current Market Instability to Your Advantage
A bear market is fully upon us after going on a rollercoaster ride in 2022. Amidst the chaos, confusion and fear are a few bright rays of hope that a savvy investor can use to their advantage. It's a time to consider buying low and taking advantage of losses. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Then There Was One
None of the three major stock indexes show even remote signs of stability as of midday today, June 16, 2022. Two of the three are in bear markets with the third standing precariously on the precipice.
The S&P 500 closed on June 13, 2022, in a bear market that technically began on January 3, 2022, when the S&P 500 hit its all-time high. It ended a bull run that started on March 23, 2020 and lasted just over 21 months — the shortest on record. Bull markets last an average of about 60 months. Curiously, this short bull market followed the shortest bear market on record, which lasted just over a month — from February 19 to March 23, 2020. Bear markets historically last about 19 months.
The Nasdaq index has been in a bear market for a while. It’s now 32%+ below its all-time high set in November 2021.
The more resilient Dow index is not yet in a bear market, but it has fallen about 16% from the all-time high it reached the last day of 2021. It might enter bear territory any day now.
Confront the Bear
I’m not suggesting that it’s time to run for the exits. In fact, I think you should stare down the bear.
And, if you have the cash to invest, consider putting some of it to work in this bear market on a dollar-cost-averaging basis, which involves buying equities at regular intervals (despite the prevailing unit price carnage). This method removes a chunk of emotion from investing.
My personal approach is to automatically reinvest all dividends and capital gains of owned assets immediately upon receipt. In short, I’m constantly buying more units of – in my particular case – mutual funds that I’ve decided to hold for the long term. I do this despite what appears to be a deepening market sell-off while expecting an increasing probability of aggressive monetary tightening by the Fed. And while many investors are unloading risky investments to buy what they consider safer assets. I'll take my chances with the assets I already own.
So where should you invest your extra cash? Savvy investors tend to target dividend stock during high-inflation bear markets. Profitable, time-tested dividend stocks tend to outperform non-dividend payers over time.
Basic necessity stocks like healthcare and utility providers can also be good choices. (Folks prefer to stay cool or warm - depending on the season - despite market shenanigans). And growth stocks typically outperform value stocks during periods of economic weakness.
But always remember this: Regardless of the depths of a market correction, and we’re having a dandy, buyers with long-term perspectives are those most likely to come out ahead of the game when the carnage is over.
Maximize Your Losses
Like it or not, this current bear market is wreaking havoc on all sorts of investment portfolios. I hesitate to guess how many trillions of dollars of short- and long-term losses American investors are currently suffering - pain that becomes reality once losses convert from paper to reality.
If you do suffer losses, use them to your advantage. It’s a fact that our tax code is somewhat generous regarding losses on assets held in taxable accounts…less so for those held in IRAs, 401(k)s, and other tax-sheltered accounts. It’s this simple. Folks have the option to sell their losers and use those realized losses to offset taxable capital gains on the sale of current…and future…winners. And it matters little what types of assets yield those winners and losers (e.g., a loss on the sale of a stock can offset the gain on the sale of a bond, a mutual fund, real estate, etc.).
And if lacking current year gains, up to $3,000 per year of losses can offset ordinary income such as wages or interest until exhausted…in short, indefinitely. One caveat: You can’t carry losses back to offset gains from prior-year sales. Uncle Sam’s generosity has its limits.
Harvest Tax-Loss Wisely
Because ordinary income is usually taxed at a higher rate than long-term capital gains, it makes sense to annually take enough capital losses to shelter $3,000 of income such as wages and interest. Apart from that, capital losses’ maximum utility lies in their employment to offset short-term capital gains, which are also taxable at ordinary income rates. But keep an eye on transaction fees. Overzealous tax loss harvesting can erode the value of harvesting itself.
And under current law, which hopefully will remain unchanged, accumulated capital losses expire upon one’s death because there’s no capital gains tax on the appreciation of assets at the time of death. Why? The basis of assets inherited by beneficiaries are marked to market on the date of the benefactor’s death; thus, there are no longer any gains to shelter. However, all gains earned after the date of death are the new owner’s tax-loss harvesting challenge.
The IRS code postpones the use of capital losses if an investor purchases a “substantially identical” asset within 30 days before or after generating a loss. Such sales are called wash sales and apply to bonds, stock, funds, ETFs, and other securities. Notably, a wash sale also applies when an investor generates a loss in a taxable account and then buys a substantially identical asset in a retirement account within 30 days. So beware.
Currently, because they aren’t deemed securities, there is a wash sale exception for cryptocurrencies. As cryptos continue to grow in popularity (or will they?), this exception status might change.
Many Happy Returns
Studies show that careful harvesting of losses can add from 0.5% to 1.5% per year to total returns if an investor is fastidious about the effort. For this reason, in our current chaotic and bearish marketplace – which is likely to produce a plethora of value thrashings – loss harvesting might soon attract more and more attention from reeling investors.
Try it, you might like it.