Lemonade Anyone? 5 ways to turn ugly stock markets into beautiful opportunities
5 Ways to Turn Ugly Stock Market Environments into Beautiful Opportunities
By John H. Robinson
I am always amazed at the tremendous fuss that is made whenever the stock market decides to decline for a bit. I find it extremely difficult to accept that millions of investors purchased shares of stocks and/or stock mutual funds/ETFs without anyone ever explaining to them along the way that sometimes the stock market goes down.
I believe most people truly do understand this in theory, but for many, a lack of experience in going through prolonged down markets and primal loss aversion instincts create self-doubt when the theory turns into big value declines on their very real investment account statements. Negative financial media hyperbole fanning the flames of fear does little to quell the queasy feelings. I also believe most investors (and certainly all the people for whom I work!) have been cautioned not to give in to fear by panicking in down markets. As the late legendary investor Sir John Templeton famously quipped, “The four most expensive words in the English language are “this time is different.””
Any readers of this column who have ever asked me if I think the stock market is going to go down, likely know my patented response – “Yes. Absolutely it is going to go down!... I just don’t know when, how much it will fall, or how long it will stay down, but I am certain that it will go down. This certainty is not attributable to an innate ability to predict the stock market’s behavior, nor is it rooted in a nihilistic outlook toward the future of capitalism or the domestic or global economy. My certainty is simply based on a firm understanding of how the stock market works.
My challenge as your financial planner is to get you to feel as comfortable and at ease as I am in investing through periods when the stock market is down (and sometimes even waaaay down). A key is to maintain perspective. Part of maintaining perspective comes from understanding what you really own when you invest in the stock market. Making investing tangible was the theme of my recent “Wheat from the Chaff” post. In today’s post, I introduce a different element of perspective – understanding that stock market declines are not only perfectly normal and natural, but they also present wonderful opportunities for building wealth and achieving financial security.
To begin, the behavior of the stock market is perfectly analogous to the weather in Hawaii. Most days are sunny, but sometimes it rains. When it rains, sometimes the showers are fleeting and other times the storm system stays for a while. The latter is a bummer if you were only visiting for a few days and were looking forward to beach time, but if you live here, you realize that rain is cleansing and is essential to making our little piece of paradise green and lush. Hopefully, you are picking up on all the metaphors here, but to help crystallize these concepts, here are a few examples of how rainy days in the stock market may create welcome opportunities for investors -
- Get unwanted/unpredictable capital gains distributions off your tax return.
When we review client tax returns, one of the first entries we seek out is the amount of capital gains distributions the client receives from mutual funds. For all their wonderful attributes, mutual funds – especially actively-managed funds – can present a tax headache when purchased outside of tax-sheltered retirement accounts. When consumers invest in open-end mutual funds, many are unaware that the fund managers are required by the end of each calendar year to distribute the capital gains realized from the sale of securities in the fund portfolio to every shareholder. This amount is taxable and is reported to the IRS regardless of whether the investor receives the distribution or elects to reinvest.
We regularly find clients with thousands of dollars of capital gains distributions reported on their returns. These distributions sometimes are enough to boost the clients into a higher tax bracket and/or to subject to clients age 65+ to a Medicare surcharge. Simply selling the mutual funds and buying more tax-efficient index ETFs may significantly reduce or even eliminate this unpredictable tax liability, but the tax hit from making the change during up markets may be prohibitive. Down markets, however, may create a window of opportunity to make this change without a big tax hit.
NOTE: A common concern when we propose this recommendation is, “But I don’t want to sell the fund when it is down!” To be clear, you are not really selling really “selling low” if you move from one tax-inefficient stock fund to another more tax-efficient stock fund.
- Take advantage of depressed IRA values by processing Roth Conversions.
Supposed you had $100,000 in an IRA last year that you were planning to convert to a Roth IRA, and it is now worth only $75,000. The taxes due on the $75,000 conversion will be considerably lower than the taxes due if you had converted when it was worth $100,000. The challenge, of course, lies in picking the best time to convert. We obviously do not know that we are at or even near the market low now. One way to address this may be to effect multiple partial conversions throughout the year.
- Generate passive income and hedge inflation by buying depressed shares of healthy companies that have a history of increasing their dividends over time.
Readers of my content know I have been proselytizing the benefits of Series I savings bonds and treasury inflation protection securities (TIPS) as solutions for keeping up with inflation. Both investments offer little or no interest but promise to ensure that your principal maintains purchasing power. What if there was an investment that both paid income and kept pace with the cost of living?
That is the value proposition of rising dividend stocks. The depressed stock market has raised the dividend yields of many health companies to the 3-4%+ range. Many of these companies have historically increased their dividends by 5-10%+ per year. Since what you are buying is shares in a company, there is obviously nothing guaranteed about the share price or income, but the concept of buying a diversified basket of rising dividend stocks for an income stream that may keep pace with inflation along with some stock price appreciation over the long run is a time-tested strategy. These days, there are plenty of solid, well-known companies that seem likely to pay rising dividends for many years to come.
- Keep or even increase your employer retirement plan (401(k), 403(b) 457(b)) contributions.
The biggest mistakes made by 401(k) plan participants during bear markets include stopping their salary deferral contributions and moving their savings out of stock funds into “conservative” bond funds. This is exactly the opposite course of action that most financial planners recommend. It may sound counterintuitive, but investors who are saving for retirement should actually hope the stock market goes down and stays down over their working years and goes back up only when they need it for spending in retirement. Although it is not realistic that the stock market will remain depressed for decades, plan participants may do well to turn current market lemons into lemonade by continuing to invest through the downturns.
- Use the downturn to diversify concentrated positions in a single stock.
Many consumers who have worked for decades at a publicly-traded company end up with a pile of employer stock. Upon retirement, they may recognize the need to diversify the position but may be reticent to do so because of the capital gains implications. The depressed stock prices may offer a window of opportunity to minimize capital gains tax implications.
Far from being foreboding, these examples tangibly demonstrate how bear markets create wonderful opportunities for investors. Of course, the corollary of the question to “Do you think the stock market will go down?” is “How do you know the stock market will eventually rebound and go higher in the future?” I also addressed this in my “Wheat from the Chaff” post by explaining how companies with real earnings each year will eventually be worth more over time. To support my position further, I close this missive with the following excerpt from a 2017 interview with Warren Buffet titled “Warren Buffett predicts the Dow will hit 1 million and that may actually be pessimistic” (CNBC) -
At a party for Forbes magazine’s centennial earlier this week, Buffett said the Dow Jones industrial average will be over 1 million in 100 years, up from 22,397 currently (which is near a record, by the way).
The 87-year-old acknowledged there’s a strong likelihood he won’t be around to take a victory lap on his prediction, but he also said it isn’t unreasonable.
He pointed out the Dow was at 81 a century ago. It was first created in the late 1890s to represent a basket of 30 big American companies.
But Buffett’s value-investing fellow billionaire, Mario Gabelli, joked on Twitter about whether Buffett’s normally sunny outlook had darkened given the numbers. “one million in one hundred years ...has Buffett turned bearish?” Gabelli said in a tweet Thursday.
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The information contained herein is general in nature. Neither Financial Planning Hawaii nor J.W. Cole provides client-specific tax or legal advice. All readers should consult with their tax and/or legal advisors for such guidance in advance of making investment or financial planning decisions with tax or legal implications