What To Do In A Down Market

As any investor could tell you, the markets are off to a rough start in 2022. Both stock and bond markets are facing an unusual number of headwinds these days, including high inflation, rising interest rates, snarled supply chains, a lingering global pandemic, the war in Ukraine, disruptions in food and energy production, and very hawkish rhetoric from the Federal Reserve.
The combination of these and other factors has weighed on most asset classes this year, with high-flying growth and technology names bearing the brunt of the downturn. While the S&P 500 is down around 17% year-to-date, the Nasdaq index of U.S. large growth companies is now down more than 30% from recent highs, which is worse than the decline in March 2020 as the COVID-19 pandemic was unfolding. Foreign developed and emerging market stocks are also down around 14 to 16% this year. One of the brighter spots has been U.S. and international value stocks, which are suffering a much more moderate decline of about 5 to 7% this year.

We never like to see losses in our portfolios, but as long-term investors, we know that market drawdowns, while unnerving, are normal and expected, even if their timing is unpredictable. Short-term volatility is often the price we pay for long-term, positive real returns. But when markets are on the move as they have been lately, investors can feel a sense of urgency to do “something,” which leads naturally to the question “What should investors be doing in a down market?”

First (after taking a deep breath!), we should recognize that our actions, unfortunately, will have no effect on what the markets will or will not do. Importantly, we can’t control the markets, but we can control our own reaction to market moves. We also know that attempting to “time” the markets has not proven to be a viable path to a successful investment experience and is more likely to be an exercise in frustration. There is no evidence that retail or professional investors can accurately predict when to jump out and back in the stock market with any consistency.

Secondly, we have always advocated that significant changes to your portfolio should result from changes in your personal situation (e.g., retirement, a change in health status, an inheritance, a change in risk tolerance, the birth of a child, etc.), and not what crazy thing the markets may be doing at the moment. We believe that in most cases, the right move during a down market is to review and validate your overall financial plan without making any changes to your investment strategy.

Finally, while market timing is not likely to be beneficial to your portfolio, market drawdowns and volatility can present other opportunities, some of which are listed below:

  • From our perspective, volatility provides an opportunity to rebalance our portfolios by selling a portion of recent winners and reinvesting in other asset classes at lower prices. This maintains the target risk profile of the portfolio and can help to enhance long-term returns.
  • Tax-loss harvesting: In taxable accounts, there may be an opportunity to sell position(s) with unrealized capital losses, which can be used to offset against future capital gains, lowering our overall tax liability.
  • Replace mutual funds with lower-cost ETFs. The list of available exchange-traded funds continues to expand, and it is easier than ever to cover the major asset classes with potentially cheaper and more tax-efficient ETFs. Down markets allow for this fund conversion with a smaller tax impact.
  • Contribute to retirement savings accounts (IRAs, Roths). For those who are eligible, now might be the right time to consider making an IRA or Roth contribution while markets are lower.
  • Do you have college-bound children? Now could be the time to open and fund a 529 college savings plan for them. You might even be able to lower your state income tax bill this year — some states allow for the deduction of 529 contributions (up to a certain limit).
  • And finally, you might consider performing a Roth conversion (from IRA to Roth) while markets are down. When markets turn around eventually, gains in the Roth account won’t be taxed when withdrawn. (Note that conversions are generally considered taxable income.)

Even for long-term, evidenced-based investors, enduring a market downturn is never fun. But we also know that corrections are a normal and expected phase of the investment experience. When markets become volatile as they are today, investors are frequently tempted to sell or otherwise make major changes to their investment strategy. In most cases, this would be a mistake — doing nothing is preferable to making an emotional decision in the heat of the moment. Instead, a better move is to take advantage of market volatility by using the opportunity to rebalance our portfolios, recognize taxable losses, and contribute to our investment accounts while prices are lower.