Seek First to Understand
It might seem so obvious that it’s silly to point out, but the first thing I do when the market makes a big move is try to understand the cause. Do I already have a good explanation for the current activity or is there a piece of information I might be missing? Knowledge is power and being well informed can help you determine your next steps. Although I have been an investor since I was a teenager (thank you, Dad) and a professional in the investments industry for over a decade, there is always something to learn. I view every period of volatility as an opportunity to become a more informed investor.
In a world where information is regularly mingled with opinion, it’s important to have trusted sources of information and to gather a variety of perspectives. Nobody has all the answers, and nobody is right every time. As a recipient of this newsletter, you have Howe & Rusling to provide balanced insights into market activity and we will always do our best to provide you with measured analysis of current market events. If you haven’t read it yet, I highly recommend taking a few minutes to review our insights piece from last week by Sarah Swan, CFP®, A Check-in on Tariffs and Markets.
Review The Fundamentals: Risk Tolerance, Cash Reserves, Financial Plan Updates
Participants in the stock market range from speculators taking risky bets on longshot odds with large potential payoffs, to day traders reading charts and making money on short-term price changes, to investors who buy assets based on underlying value and the expectation for increasing value over time. Each of these participants takes a calculated risk, but the fundamentals for each differ greatly. The foundation upon which investors build their strategies are 1) understanding the risk of the proposed investment and 2) the time horizon for their investment. There are other considerations depending on the situation, but these two building blocks are always present. When volatility spikes it can be a valuable opportunity to revisit the foundation of your investment strategy and determine if it has changed.
The risk of a proposed investment strategy is quantifiable. We have plenty of historical data and volatility statistics for any given investment. Risk capacity is how much risk an investor can afford to take on. This is also quantifiable to a large degree and can be determined through practices such as financial planning. The challenge is aligning that measurable data with your tolerance for risk. Risk tolerance is how you feel about taking on risk with your investment portfolio and it’s difficult to quantify. Risk tolerance is often divined with an approach similar to a doctor asking you to pick the appropriate smiling or frowning face on a pain chart. However, one person’s interpretation of the scale may be different than another. It is also common for people to overestimate their tolerance for risk when stock prices are going up for an extended period of time. We often have a much clearer sense of our true risk tolerance when price shocks occur. It’s also true that risk tolerance can change, and it often declines as an investor ages. That is why it’s important to review risk tolerance on a regular basis. Periods of market volatility can be an effective reminder and a tool for accurately assessing risk tolerance.
Cash reserves are another fundamental tool for managing risk in a financial plan. When stock prices decline it can be a good prompt to revisit your cash reserves and ensure those levels are appropriate. Cash reserves play a different role depending on an investor’s stage of life.
For an investor who is still working and saving, cash reserves offer a safety net should they lose their job and not have income for a time. A guideline for cash reserves for a working person is to have three to six months of expenses set aside. With this cash reserve available in a pinch, the investor can avoid drawing against their investments while they search for a new job.
For a retiree or someone quickly approaching retirement, that cash reserve might be substantially higher. The years leading up to and immediately after retirement might be a “high water mark” for an investor’s cash reserves. The role of the cash reserve is a bit different for this investor because it is used as a buffer against needing to liquidate investment assets for income at a time when stock prices fall. Many investors approaching retirement express concerns about seeing a bear market right before they retire. A sufficient cash reserve can help manage this risk.
Since we’re discussing bear markets, let’s take a moment to define that term and review the history of bear markets. The definition of a bear market is a decline in a market index, like the S&P 500, of 20% or more from recent highs. There were 11 bear markets between 1950 and 2024, but another five declines of more than 19% which is close enough to be included. Measuring from the peak level before those 16 periods, it took on average 30 months for the stock market to recover to that same value (peak to trough to recovery). Now that is just an average and the length of each bear market was different, but only four of those declines took longer than three years to recover to pre-decline levels. If an investor has appropriate cash reserves planned and set aside, then they will be better positioned to weather a market downturn without needing to tap into their investments during a decline. That allows time for investment values to recover.
Bull and Bear Markets Since 1950
As a third fundamental it’s a good practice to review your financial plan annually to see if anything substantial has changed since the last review. It’s amazing how much can change in a year! Has your income grown or decreased? Have expenses changed? What about your risk tolerance or retirement plans? Do you have a big expense coming up? You may find after reviewing your assumptions that a formal update isn’t necessary, but it’s worth taking a look. A financial plan is much more than just investment management and working on other financial priorities can be a good way to take control when investment volatility spikes.
Can This Work in Your Favor?
Sometimes you can make a significant decline in stock prices work in your favor. A few examples of this are rebalancing, Roth conversions, moderating concentrated stock positions, and executing stock options. Each of these situations will require a review of your unique circumstances, but there may be some opportunities for tax planning amid the volatility.
Rebalancing is a good practice as an investor and it’s something that we do at Howe & Rusling. The idea behind rebalancing is that some investments in the portfolio will grow faster than others and rebalancing helps manage risk by maintaining a consistent asset allocation. Usually stocks grow at a faster pace than bonds and a rebalance involves taking some of the gains from the stock portion of the portfolio and reallocating to bonds. However, if stock prices decline sharply and bond prices hold up, that may present an opportunity to rotate some assets from bonds into stocks at a lower price during a rebalance.
A Roth conversion is the process of moving funds from a Traditional IRA to a Roth IRA (or from Traditional to Roth within a retirement plan like a 401k). This allows the taxpayer to pay taxes on retirement assets now to withdraw the growth on those assets tax-free in the future. A Roth conversion requires the tax payer to claim the full amount converted to Roth as income taxed at their ordinary income tax rate. If the assets in an IRA are largely in stocks and stock prices drop, then that presents an opportunity to convert shares from Traditional to Roth with a lower income tax burden.
Another tax planning opportunity when stock prices fall is to moderate concentrated stock positions in taxable accounts. Highly concentrated stock positions can create concentration risk in a portfolio. When that concentrated stock position is in a non-qualified taxable account, selling shares to manage concentration risk may create a tax liability from realizing gains on that stock. That investor then has to choose between concentration risk and tax liability. However, if the price of that stock falls, the gains also shrink. That presents an opportunity to sell a greater number of shares for a smaller tax liability and to diversify into a broader basket of stocks. Think of it as buying more diversification for less tax cost.
In a similar vein, a decline in stock prices may present an opportunity to exercise stock options. Certain employer plans like non-qualified stock options provide employees with the option to buy shares of company stock. When non-qualified stock options are executed the difference between the grant price and the fair market value at execution (the spread) is taxed as ordinary income. This can potentially create a large tax liability, especially if the tax payer is in a high marginal tax bracket or the spread on the options is wide. Non-qualified stock options often have several choices for how to execute them. Typically this will include paying the exercise price and holding the shares or exercising the options and then selling just enough shares to cover the taxes and price of the remaining shares. In both of these scenarios, after exercising the options the employee owns shares of company stock in a non-qualified account. Should the employee continue to hold those shares for longer than a year, then the gains after exercising the options will be taxed at long-term capital gains rates. If the employee wishes to hold the stock long-term and believes a decline in the stock price is temporary, that creates an opportunity to pay less taxes on the gains of that stock in the long run.
Everyone’s situation is different and not everyone will have opportunities for tax advantages in a market decline. Some of these decisions can be complicated and this article is not intended to go into great detail on any of these strategies. If you think one of these options might benefit you, we would be happy to discuss it with you and help you plan. Even if these strategies don’t apply, everyone can revisit the fundamentals of their investment portfolio and make sure their investment policy is up-to-date. Although the stock market is beyond our control, we can work together to strengthen other key aspects of your financial plan. Howe & Rusling is here to help.
Disclosures: This material is provided for informational and educational purposes only and should not be construed as investment advice or a recommendation to buy or sell any specific securities. The views expressed are those of the author as of the date of publication and are subject to change without notice. Any opinions expressed do not necessarily reflect the views of Howe & Rusling. Past performance is not indicative of future results. All investing involves risk, including the potential loss of principal. There is no assurance that any investment strategy will be successful or achieve its objectives. Certain statements contained herein may constitute “forward-looking statements.” Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. Any references to specific securities or investment strategies are for illustrative purposes only and do not constitute a recommendation or solicitation by Howe & Rusling to buy, sell, or hold any security. The mention of a security should not be interpreted as an opinion regarding its suitability for any specific investor. This communication may contain general information related to tax strategies or considerations. Howe & Rusling does not provide tax or legal advice. Please consult with your tax or legal advisor regarding your specific situation before implementing any strategy discussed herein. Data presented regarding market performance, bear markets, or recovery periods is based on historical information believed to be reliable; however, accuracy and completeness are not guaranteed. Market indices are unmanaged and not available for direct investment. Howe & Rusling is an SEC-registered investment advisor. Registration with the SEC does not imply a certain level of skill or training. Rebalancing and diversification do not guarantee a profit or protect against loss in declining markets. It is a strategy designed to help manage risk and maintain a desired asset allocation.
