How to Take Advantage of Volatile Markets

In a recent post, we explained why we do not try to guess the impact on the stock market of international events, such as the Brexit vote in the UK or the slide in oil prices this past winter, and why we believe it is counterproductive to try to “time the market” and trade in and out of stocks based on an assumption of how stock prices will react to such events.  However, that does not mean that we, as passive investment managers, are oblivious to short-term changes in the market.  There are a variety of ways that we do–and any passive investor, in good conscience, can–react to market volatility, as discussed below.

Use Cash to Buy Stocks “On Sale.”  First, and most obviously, market downturns provide excellent opportunities to buy stocks “on sale.”  While we would not advise “buying low” with the intention of trying to sell again in the near future once the market has rebounded, if you do have cash available for long-term investing, you may want to take advantage of a temporary market dip (since, fortunately, all past market dips have been temporary) to get those funds invested.  Two potential ways to accomplish this are as follows.  First, if you have higher balances in checking or savings accounts than is necessary and comfortable for an emergency fund, some of that cash may be invested during a market downturn.  Second, you may choose to let cash accumulate in your investment accounts, which can provide additional opportunities to buy low during downturns.  Many investors elect to have interest, dividend, and capital gains distributions from their mutual funds automatically reinvested in the same fund, but if, instead, you choose to have them paid out in cash, you can then periodically invest all of the cash in whichever fund is most “on sale.”  If you choose to do this, however, we would still advise investing the cash on a regular (e.g. quarterly) basis, not in reaction to market conditions (see our post on portfolio rebalancing for details).  If stocks are not “on sale” (i.e. the stock market is up) when you have cash to invest, that may be a good opportunity to add some bonds to your portfolio.

Realize Tax Gains or Losses.  Another opportunity afforded by volatility in markets is to realize tax gains or losses.  If you are in a high tax bracket and/or expect to pay significant capital gains tax in a given year, you might consider selling a portion of your investments during a market downturn to realize tax losses (assuming you have losses to realize, i.e. you paid more for an investment than its current value).  The only trouble with this strategy is that in order to avoid a wash sale, which will basically nullify your tax loss efforts, you have to wait 30 days before buying the investments back again, and depending on the tax savings, an upturn in the market during those 30 days could result in a greater financial gain than selling the investments to realize a tax loss.  This is also a good reason for only attempting to realize tax losses with a small portion of your portfolio, not taking a significant chunk out of the market for 30 days or more.  Conversely, with respect to investment gains during a market upturn, you may consider selling some investments to realize those gains (and then buy back the investments the next day) if you know that you will be in the 10% or 15% tax bracket for that year (or have a capital loss carryforward from prior years).  Taxpayers in those two brackets do not pay any tax on capital gains, therefore you can reset your cost basis–essentially, drawing a new line in the sand past which you will need to pay capital gains tax on any investment growth–which could be an advantage if you anticipate being in a higher tax bracket in future years.

Changing Automatic Monthly Investments.  A final change for a passive investor to consider in volatile markets is to make adjustments to any automatic monthly purchases or sales of investments.  Many working investors make monthly purchases in their taxable investment accounts and/or IRAs, while some retired investors may make monthly sales in their IRAs to raise cash for needed withdrawals.  This is known as dollar cost averaging (DCA), and it helps take the guesswork out of movements in or out of the market.  However, a particularly significant swing in the market may be an impetus for increasing or decreasing DCA amounts or changing the types of investments being bought or sold.  For example, during a market downturn, a retired client may want to decrease DCA sales (if they can make do with less cash) and/or adjust the DCA sales to draw more heavily from their bond holdings than equities.  In contrast, a working client may want to increase DCA purchases (if possible) and/or adjust the DCA purchases to buy fewer bonds and more equities.

Despite being firmly committed to a passive investment strategy, there are many ways that we as passive investors can and do react to volatile markets.  If you have questions about how this relates to your portfolio, please give us a call!