It’s that time of year again when we collect and organize our activities from 2021, and file taxes before the April 18th deadline. And in 2022, we’ve started the year off with a stock market correction.
When the market enters “correction territory” is completely arbitrary, but how to recognize that it has is easy to remember!
When the market drops 10% it’s a correction. A bear market is when the market drops 20%.
Right now, we’re flirting with a 10% drawdown for both US and ex-US stocks. Bonds are also experiencing a drop.
But this isn’t a post about what comes next for the market, it’s about the planning and investing moves you can make during sustained periods of market downturn.
The normal advice during market drops is to do nothing and stay the course. Unfortunately, this advice doesn’t feel very proactive. Many investors feel the need to do something. The good news is that there can be many productive things to do. Just no radical portfolio changes based on emotion, please.
Behaving well with your investments can make or break your financial plans, especially during extremes like market corrections or raging bull markets. Then again, financial planning is so much more than an investment portfolio. But market volatility can provide a nice, non-routine opportunity to improve our financial futures.
The current environment could be beneficial for our 2022 financial goals!
Below is a checklist we can all use to make sure our plans stay on track, no matter what our goals are.
Issues to consider during a market correction
Let’s start by pivoting away from a dropping market and focusing on cash flow.
- Check your safety net. Good income planning includes building a safety net. Usually, this is a three-six month cash reserve to protect against income setbacks. Additionally, this emergency fund should also include large near-term purchases. Double check your cash and money market funds to make sure you can weather any storm.
- Revisit your withdrawal rate. It’s common for us to use the 4% rule as a retirement income guideline. The 4% rule says to withdraw no more than 4% of your portfolio each year. This way it will last for as long as your needs last. Now is a good time to make sure 1) your spending levels are safe, and 2) you have three years of cash in your war chest to cover expenses in case of an extended market downturn.
- Look for extra cash. What if, after reviewing your safety net, you realize you have too much cash sitting idle? If that’s you, consider investing it to take advantage of lower stock prices. Just make sure you can live without the funds for at least five years. Investing takes patience, and there is no guarantee prices won’t drop more once you invest.
- Make IRA contributions. Individual retirement accounts are excellent vehicles to use for tax-advantaged investing. If you have not yet fully funded your non-employer sponsored accounts for 2021, or any of your accounts for 2022, you still can. With prices dropped, now could be a great time to contribute to these accounts and invest.
- Consider Roth conversions. If you have a 401(k) or traditional IRA, converting some of the assets into a Roth IRA could be beneficial while prices are low. This will help you move investment funds to a tax-free account and reduce your potential tax liabilities in retirement.
- Harvest capital losses. Tax-loss harvesting during a market correction is an excellent reason to take action. Harvesting losses and rebalancing your portfolio can help reduce tax liabilities associated with unrealized gains. Just don’t run afoul of wash sale rules.
Protecting what’s important
- Revisit your estate plan. A market correction is good time to review the impact lower prices may have on the ultimate distribution of your estate. They are not always applicable, but lower prices could help you implement wealth transfer techniques to put more into trust vehicles for your beneficiaries.
- Make annual gifts. Embarking on the choice to make annual gifts to heirs is not always black and white. However, if you’ve already started, or if you plan to start, now may be a good time. Gifting assets now (up to $16,000 per person, per year, tax-free), while prices are low, will allow heirs to capture the benefits of the rebound. Gifting stocks can benefit you too, because when you gift appreciated assets that fly below the annual gift tax exclusion limit, you don’t have to pay taxes on gains.
Investing during a downturn
- Check 401(k) contribution rates. Most plan sites make it very easy to adjust your contribution rate into your employer-sponsored retirement plan. During a market correction, it can be a great time to inch up your savings rate. Once recovered, you can dial it back. By upping it now, you can take advantage of dollar cost averaging into lower prices.
- Review asset allocation. It’s a fact that we don’t really know our risk tolerance until we experience risk. Well, market corrections are the manifestation of risk, and provide an opportunity to recalibrate. We like to match investment objective to goals, and depending on the goal, this could mean a stock-heavy allocation. Stocks are for growth and for long-term investing. During market corrections, take your pulse, and then see if changes are needed when conditions improve.
- Rebalance. Depending on the scope, breadth, and depth of a correction, rebalancing may be required. When a correction is bad, our intended long-term stock and bond allocations get out of whack. We’ve talked about it before, but if you go into a correction with 80% stocks, you want to exit the correction with 80% stocks. Rebalancing helps keep your plans on track.
Simple, but not easy
Having a retirement plan, an income plan, and an overall financial plan is important for situations like we find ourselves in. A good plan, with the help of a good adviser, will tell you what to do when the proverbial you know what hits the fan.
Sure, inflation is up, growth stocks belly-flopped after an epic 2020, and Russia just invaded Ukraine. It’s all very concerning and fear inducing, yet, a lot of this is out of our control. What is in our control is behaving well in times of stress, managing spending levels, managing contribution rates, and managing how much risk we take.
We’re here to be your guide. If you’d like to discuss how these issues apply to your financial situation, schedule a free consultation with one of our fiduciary advisers.