We’re having a darn good run. Since its low point in March 2009, the S&P 500 has returned over 300%. This recovery is the second longest bull market on record, lasting over eight years. And with a CAPE ratio of about 29, U.S. stocks are historically expensive relative to their corporate earnings. Given all of this information, it is entirely understandable that some investors are getting a little nervous about the market’s future potential.
So, what lies ahead? John Maynard Keynes famously said that “markets can stay irrational longer than you can stay solvent.” Much as interest rates have stayed low for a very long time, markets can stay expensive for a very long time, negating any value to trying to time when to invest. Despite this viewpoint—and abundant evidence that market timing probably won’t make you better off in the long run—as investors, it’s difficult to be rational about the market’s irrationality when faced with tough news—or even the potential of tough news.
At Betterment, we understand this. Though we don’t recommend trying to time the market, we know that worse things may happen when investors hold a portfolio they aren’t comfortable with. So rather than just saying, “don’t do anything, folks,” we’ve developed five concrete steps you can take now to get ahead of market volatility and stick with your long-term plan.
1. Decrease your risk moderately, but don’t ignore taxes.
Once you’ve decided you think the market holds less potential for growth in the short term, it’s tempting to whipsaw your portfolio down to zero stock exposure. Unfortunately, we have found the more you change allocations, the more likely it is you’ll underperform. And not just because of subsequent market returns; each time you trade, the market takes a tiny bit out of the value of what you trade. So while you might get lucky, the odds are against you over time.
Also, if you’re trading in a taxable account, ignoring taxes when making investment decisions is one of the biggest mistakes you can make. You may think a market downturn is on its way, but, in truth, you can never know for sure exactly when it will happen. Look back at old broadcasts of financial television from 2016 or 2015; there were plenty of pundits predicting the market would face a major correction before the end of the year. And yet, here we are—no downtown yet.
Many an investor has missed more in gains than they’ve avoided in losses by trying to time a dip. What is certain is that you will owe taxes on any net capital gains you incur from selling out of stocks and going into less risky investments like bonds or cash.
That’s why we built Tax Impact Preview—to help you see how much in taxes you could owe before finalizing your trade. Our technology allows us to analyze each specific investment you hold and calculate the estimated capital gains/losses you could incur from selling it.
It’s okay to slightly decrease the risk in your portfolio if it helps you sleep at night. Each investor has his/her own tolerance for risk. That is why Betterment is personalized to provided recommended ranges of risk for each goal. If you are nervous about the market, you could slide down from “Moderate” to “Conservative.” Just be aware of the tax impact it could cause.
2. Divert regular savings into a “dry powder” fund.
If you believe stocks are overvalued, you may wish to temporarily stop purchasing more of them. However, that doesn’t mean you should stop saving altogether. Instead, redirect your regular monthly savings into an account we often call a “dry powder” fund. Parking money in your dry powder fund will allow you to continue your good savings habits while building a stockpile you can deploy if the market does take a dip.
A good dry powder fund should be extremely low risk and very liquid, meaning you can access the money quickly. A traditional savings account could do the trick, but at Betterment, we also created a portfolio for exactly this purpose. It is built entirely of US short-term Treasuries, with AAA credit quality and average maturities of less than six months. Another benefit is that you can transfer money from one Betterment account to another with great speed than processing a deposit from your bank account.
The graph below shows how the US Short-Term Treasuries ETF (abbreviated SHV) compares to the World Stock Markets (ACWI) fund. While the latter fund has had plenty of ups and downs, the “dry powder” fund, the SHV, is nearly a flat line—steadily holding its value. While, of course, historical performance is not a reliable predictor of future performance, but, if investing for dry powder, I’d take my chances on a flat line over a hilly line any day.
Source: Data provided by XIgnite
A dry powder fund can be a great alternative if you are nervous about the market, but be aware of how large your balance gets. Keeping too much cash (i.e. cash equivalents) for too long is a sure-fire way to lose purchasing power due to inflation.
3. Reassess how your investment strategy aligns with your goals.
“Most things work—until they don’t.” When you apply such common sense to investing, it means you can get away with an overly aggressive portfolio relative to your goals—even for a long period of time—but eventually, an overly aggressive mentality will likely backfire.
Smart investors make sure their investments match their goals and time horizons. The market may be unpredictable, but your goals and plans are far more predictable and under your control.
If you have a short-term goal, like purchasing a home, you shouldn’t be taking a lot of risk with that money. If the market does go down, you simply won’t have enough time to recover. A prudent approach is to decrease your portfolio’s risk as your goal approaches. You can see a visual example of a major purchase goal below.
Major Purchase Goal
4. Have a game plan.
The biggest investment regrets are often from knee-jerk reactions to events beyond our control. The most recent Federal Reserve Survey of Consumer Finances shows that the number of individuals who own stocks has declined by 4.4% since 2007, despite the market recovery. In other words, many individuals exited the market during the Recession, rather than riding the bull market upward from 2009 onward.
You cannot control the stock market, but you can control your behavior. When you expect market volatility, it’s best to plan ahead. Ask yourself questions like the ones below, and consider even writing down your responses for your future self.
- How often should I check my investment accounts?
- How long of a “cool-off” period will I give myself before executing a withdrawal/trade?
- What is the maximum number of trades I will make per year?
- What’s the maximum I’m allowed to deviate from my long-term allocation?
Having a personalized rulebook like this should be part of every investor’s game plan, so that rash thinking in the heat of the moment doesn’t lead to later regret.
5. Start tax loss harvesting.
Despite your best efforts, no strategy can entirely safeguard you from the short-term ups and downs of the stock market. You can actually use these temporary market downturns to your advantage. Tax loss harvesting can save you money, and it can increase your after tax-tax returns by up to an estimated 0.77% per year through actively realizing short-term losses, and using them to offset taxes.
When you sell an investment at a loss, you can use that loss to reduce taxes on other capital gains as well as earned income. Advisors have been using this strategy for decades when assisting wealthy clients, but technology now allows us to do it much more efficiently for Betterment clients throughout the year.
Putting It All Together
Personal finance is only one part math; the other nine parts are behavior. Betterment stands by our evidence-based investment approach that trying to time the market is not a prudent strategy. But we also understand that, as humans, not taking action during a market downturn is extremely difficult for people. So if you are nervous about what lies ahead with the stock market—now or in the future—try one of the five tips above.
Decrease your risk slightly, but be mindful of taxes. Don’t stop saving entirely, just redirect your savings into a dry powder fund. Make sure your investments match your goals. Have a game plan that you are comfortable with, and commit to sticking to it ahead of time. Lastly, take advantage of market volatility with tax loss harvesting.
These five tips will help you take control of your portfolio and stick with your long-term strategy.