The third quarter delivered mixed results from capital markets. Broad domestic and international indices entered negative territory, while emerging market equities and commodities returned -10% or worse. While the volatility may have surprised some investors, drawdowns of this magnitude are well within the historical range of short-term outcomes in equity markets. Smart investors will take the market volatility as an opportunity to rebalance their portfolios, confirm cash needs, and implement other techniques, described below.
- Plan ahead for cash flow needs
Don't invest cash reserves in long-term investment portfolios. Review your cash needs for the next 12 to 24 months. Develop a timeline that includes payments you need to fund that are not covered by your monthly income, and offset these by conservatively anticipated cash additions. Needs for cash can include capital calls, a new car, taxes, a down payment for a home or recreational vehicle, medical treatments, gifts to charities or family members, and 4-6 months of living expenses (your emergency fund) and more. Contributions might include annual bonuses, distributions from private investments, or the sale of real estate. Keep the present value of your net cash needs in a conservative and liquid portfolio strategy comprised primarily of cash and short-term fixed income investments. You may find you have extra cash on hand that can be deployed into longer term assets, taking advantage of market downturns.
- Confirm sources of liquidity
Consider your sources of cash. In times of financial stress, lenders typically provide access to liquidity to the extent they do when financial conditions are strong. If you have equity in your home, consider getting a Home Equity Line of Credit (HELOC) in place to give you access to additional liquidity when it is needed. The costs of establishing a HELOC can be offset by the comfort of having additional sources of liquidity. Typically interest costs are paid only on outstanding balances. Plan ahead for options exercise or concentrated stock diversification to increase your liquidity, and to methodically reduce the risk of holding a concentrated position. This approach may also offer opportunities for tax planning. Sales programs based on dates rather than price, including 10b-5-1 plans, can provide more effective ways to systematically reduce concentrated positions. Waiting for an ideal price may mean never selling.
- Check portfolio anchors
When equity markets go through a period of negative performance, take the opportunity to confirm whether or not your portfolio anchors are doing their job. High quality bonds and lower volatility liquid alternative hedge funds should add value (outperform) traditional equities when equities turn south. If your portfolio anchors are not moderating portfolio losses, then move into new strategies that better diversify and protect your portfolio against equity market downturns.
- Realize short-term losses
Investors who introduced new equity investments into their taxable investment portfolios in the last year may have short-term investment losses to realize. The IRS allows investors to use $3,000 of realized losses as an offset to ordinary income each year. Additional realized losses can offset realized gains. Any unused realized losses can be carried forward indefinitely to use in future tax years when needed. When selling short-term losses, it is important to avoid violating the IRS wash sale rules; otherwise the realized loss deduction may be denied. Check http://www.sec.gov/answers/wash.htm. Talk with your advisor and/or tax advisor about your personal circumstances.
- Rebalance your portfolio
Investors may postpone liquidating some of a concentrated equity position due to potentially high capital gains tax consequences. An equity market downturn can provide an opportunity to diversify concentrated positions at a lower price, thereby reducing the capital gains on the sale. Reinvesting the proceeds in a lower risk, more diversified and balanced portfolio can help the portfolio withstand market volatility.
- Watch expected dividend payouts
Before redeploying the cash from sales (through rebalancing and/or diversifying concentrated positions), consider the year-end dividend payouts schedules of mutual funds. Most fund managers begin providing estimates as early as the end of October. Hold off on investing in funds that are anticipating large distributions in December. Target asset allocations can be achieved in the meantime with ETFs, which typically pay no or low distributions.
- Convert your IRA to a Roth IRA
Investors with IRAs can consider using a market downturn to convert an IRA or part of an IRA to a Roth IRA. Pre-tax contributions and gains in the IRA will be considered as taxable income in the year the conversion is made. Check with your advisor or CPA to ensure that any tax consequences are considered in the context of the overall wealth plan.
- Consider gifting strategies
The market downturn may have provided investors with an opportunity to transfer high beta stocks outside of their estates at reduced prices. This way the appreciation of the security can occur outside of the estate, not subject to estate or gift tax when the market recovers.
If you'd like to understand how these eight investment strategies can help your year-end planning, contact us.
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