Harder Than It Looks

Adam M. Grossman

FOLLOWING THE STOCK market’s steep decline, sensible investors are faced with three alternatives. The first two are fairly straightforward, but the third option is worth some discussion.

1. Do nothing. If all of your assets are in retirement accounts and you’re comfortable with your risk level, you might choose to tune out the news and do nothing at all. Similarly, if your portfolio doesn’t include any stock market investments, you might opt to watch the market upheaval from a distance, without feeling the need to make any changes.

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 immediately reinvest the proceeds in a similar, though not identical, investment.

For example, if you owned a collection of large-cap stocks—such as Apple or Microsoft—and collectively they’re 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 careful not to run afoul of the wash-sale rule, which would negate the tax loss.

3. Rebalancing. This is the most aggressive, and potentially most profitable, of the three strategies. The idea 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, which would likely be stocks.

This is perhaps the hardest action to take in all of personal finance. Why? 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’s also the action that has the greatest potential to benefit your portfolio, because it means 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’s instructive. According to a study by Gobind Daryanani titled Opportunistic Rebalancing, there are two key ingredients to optimal rebalancing:

Rebalancing rule No. 1: Rebalancing doesn’t need to follow any specific schedule. For instance, some people favor 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 No. 2: Don’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 gets 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? Daryanani recommends taking action when your portfolio falls out of line with one of its allocation targets by more than 20%. For example, if your target allocation to stocks is 60%, you would set outer bounds equal to 20% of that 60%, or 12 percentage points. Then, if the market were rising, you would wait until your allocation to stocks reached 60 plus 12, or 72% of your total portfolio, before rebalancing.

Similarly, if the market were falling, you would wait until your allocation to stocks dropped to 60 minus 12, or 48% of your overall portfolio. Right now, that number isn’t too far away. The upshot: Hard as it may be to put new money into stocks amid the current turmoil, the research indicates that the odds will be in your favor if you do just that.

Adam M. Grossman’s previous articles include Manic Meets MathWhat Should I Do and Don’t Tinker. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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3 years ago

Regarding tax losses with index funds, how can you determine what is a significantly different enough investment not to run afoul of the wash sale rule? I have a loss in a taxable international index fund I would like to sell and would like to add money to another (different) international index fund held in an account similar to a 401K. The two funds reference different indexes and have differences, but for my purposes I thought of them as total international funds. I’m not expecting tax advice, but wonder if there is a relatively easy way to make the determination. Thanks.

David J. Kupstas
David J. Kupstas
2 years ago

I need Tax Loss Harvesting 101. The only reason I can see to do this is if the tax rate you are avoiding now is higher than the one you will be subject to later. If I sell a fund now and take a loss, I save the capital gain tax this year, but I now have a new lower basis if I buy it back after 30 days (assuming no change in value during the 30 days). When I sell down the road, I’ll have to pay taxes on the gain based on that lower basis. what have I accomplished? Now, being able to offset $3,000 of ordinary income is attractive if your marginal rate is greater than your capital gains rate, but that’s about the only slam dunk scenario I see.

California Refugee
California Refugee
2 years ago

any thoughts on tax loss harvesting in a tax deferred account (IRA)? without being able to offset other gains, taking losses to rebalance does not seem like a good move.

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