In the wake of the stock market’s recent 25% decline, investors are faced with three alternatives. The first two are fairly straightforward, but the third is worth some discussion.
1. The first option is perhaps the easiest—to do nothing. If you fit into one of the following two categories, you may conclude that the right action is to take no action at all: If all of your assets are in retirement accounts and you’re comfortable with your risk level, you may choose to tune out the news and do nothing at all. Similarly, if your portfolio doesn’t include any stock market investments, you also may choose to watch the market upheaval from a distance, without feeling the need to make any change.
2. Tax-loss harvesting. If you’re comfortable with your overall risk level but have stocks in taxable accounts, I highly recommend tax-loss harvesting. How does this work? The idea is to sell an investment at a loss and then to immediately re-invest the proceeds back into a similar, though not identical, investment. For example, if you owned a collection of large-cap stocks—Apple, Microsoft, etc.—and collectively they were at a loss, you could sell them all and purchase an S&P 500 index fund with the proceeds. This would allow you to book the loss for tax purposes while still maintaining the same overall level of stock market exposure. You could then apply that tax loss—up to $3,000—against your ordinary income. Alternatively, you could use that loss to offset capital gains when you sell another investment at a profit, either this year or in the future. This is a great strategy. Just be aware of the wash-sale rule in order to maximize the benefit.
3. The third option is called rebalancing. This is the most aggressive—and potentially most profitable—of the three strategies. The idea here is to sell investments that have gained in value—probably bonds at this point—and to redeploy the proceeds into other types of investments that have declined in value—likely stocks at this point. This is probably the hardest action to take in all of personal finance because it means parting ways with an investment that looks stable and profitable and instead opting into an investment that looks volatile and risky. But it is also the action that has the greatest potential to benefit your portfolio because it means, by definition, selling something at a high price and buying something else at a low price. It’s exactly what we all know we should be doing.
But this is easier said than done. After witnessing the stock market’s wild swings in recent weeks, you may be wondering whether it’s safe to rebalance now or if it would be better to wait. After all, if you wait, and the market continues to decline, you’ll have the chance to buy stocks at even cheaper prices. Then again, if you wait, and the market ends up rebounding, you may lose out on this opportunity.
Fortunately, there is research on this topic, and it is instructive. According to a study by Gobind Daryanani titled “Opportunistic Rebalancing,” there are two key ingredients to optimal rebalancing:
Rebalancing rule #1: Rebalancing doesn’t need to happen on any specific schedule. Some people suggest, for example, rebalancing annually. But Daryanani’s research suggests letting the market be your guide. If markets are calm, there may be no need to rebalance for months or years at a time. But when markets go to extremes, that’s when you want to respond. The upshot: While I never recommend obsessively checking account balances, it does help to be generally aware of what the market’s doing so you know when to check for possible rebalancing opportunities.
Rebalancing rule #2: You shouldn’t be too quick to rebalance. As we’ve seen over the past three weeks, markets exhibit momentum. When they’re going up, they tend to keep moving up for a while, and vice versa. For that reason, you don’t want to rebalance every time your portfolio moves just a bit out of line with your asset allocation targets. Instead, you want to give it some latitude: If the market’s going up, and you’re making money, let things ride for a while. By the same token, when the market is falling, don’t be so quick to presume that it won’t get worse. Instead, give the market an opportunity to decline further before you choose to step in. What you want to do, according to Daryanani, is to wait for an optimal trigger point before making a trade. What is that optimal point? Having evaluated the options, Daryanani recommends taking action when your portfolio falls out of line with one of its asset allocation targets by more than 20%. For example, if your target allocation to stocks is 60%, you would set outer bounds of 20% x 60% = 12%. Then, if the market were rising, you would wait until your allocation to stocks reached 60% + 12% = 72% before rebalancing. Similarly, if the market were falling, you would wait until your allocation to stocks dropped to 60% – 12% = 48%. Fortunately or unfortunately, that number isn’t too far away right now. And hard as it may be to put new money into stocks, the research indicates that the odds will be in your favor if you do.
