Moves to make in a down market

April and May of 2022 were ROUGH months in the US stock markets. As I’m writing this, the month of May closed on a high note, but that came after 8 consecutive losing weeks, where the S&P briefly touched an intra-day low of 20% below the recent peak, which is the technical definition of a bear market. Does it really count as a bear market if it only happened for less than an hour? Since then, we’ve had a nice reversal higher, especially in some of the hard-hit consumer discretionary and tech stocks.

But these past couple months have had me thinking – what should I, as a long-term investor, do during periods of prolonged downturns?

Stay the Course

Surely we all know to continue our regular contributions. The stock market is the only marketplace in the world where people are afraid to buy when things go on sale. If you just keep making your regularly-scheduled deposits (think 401k contributions with every paycheck, or maybe a monthly Roth IRA contribution), you’re buying more shares with each buy as the price goes down, and down, and down.

“Ok Josh, that’s the easy part. That’s the set-it-and-forget-it model.” Thanks Ron Popeil!

But I wondered “what can a regular investor do to increase their long-term performance, or reduce the amount of lifetime taxes that they’ll pay?”

Tax-Loss Harvesting and Roth Conversions

Tax-Loss Harvesting is when you intentionally sell a stock that is below your initial purchase price, which allows you claim that loss on your tax return. That loss can offset gains in other investments, meaning you wouldn’t own taxes on that investment gain. It could also offset up to $3,000 in ordinary income come tax time. If the loss is greater than $3,000, you can carry over the remaining loss to future tax years. Obviously this needs to take place in your taxable brokerage account, since your retirement accounts are shielded from taxes until you start making withdrawals.

Roth Conversions are when you send money from a pre-tax retirement account (think 401k, 403b, Traditional IRA, SEP-IRA) into a Roth IRA. This triggers a tax bill on the full amount of the conversion at your highest marginal tax bracket, BUT then that money is able to grow tax-free and be withdrawn tax-free in retirement. The reason to consider this move during a downturn is that your pre-tax account balance has decreased, meaning the amount of taxes due has also decreased, and then when the market recovers to make new highs, those dollars are in the more lucrative tax-free Roth IRA account to grow for your future. This move has an additional benefit of lowering your future Required Minimum Distributions, which start the year after you turn 72 years old, and increase over time because your life expectancy decreases as you age.

I wrote more about Tax Loss Harvesting in my article “The Secret Superpower of the Mini Retirement” where I provided more explanation in the way of examples, but as the market continued its slide, it reminded me that this can be good moves for people that are in their working years, too. Unfortunately, it will happen at higher tax brackets than the Mini Retiree who has little-to-no income. I would suggest that the ability to move the money from pre-tax to post-tax while values are reduced can still be an advantageous move if you can afford the additional taxes in the current tax year since it reduces your future tax liability in your retirement years.

Don’t Panic

Whatever you choose to do, the main thing is to not panic and sell. When stocks go down, it can be scary, as your hard earned money seems to disappear into thin air. But you don’t actually lose any money unless you sell those shares at a price below the price where you purchased them. The US stock market has a 100% past history of recovering from stock market crashes and returning to new all-time highs. Past performance is not indicative of future performance, but I feel safe investing in something with a 1.000 batting average (perfect, for non baseball fans).