Updated: Oct 13
The death of the longest Bull Market in history was swift, although not painless. As we survey our accounts and find individual stocks down significantly, we would be well served by implementing strategies to mitigate the impact of temporary declines, so that when security prices have recovered your tax position and net worth are enhanced.
"Life handed him a lemon, As Life sometimes will do. His friends looked on in pity, Assuming he was through. They came upon him later, Reclining in the shade In calm contentment, drinking A glass of lemonade." - Clarence Edwin Flynn, The Rotarian (November 1940)
Dear Family, Friends, and Clients:
While our fellow investors lament the state of the market, we will focus our time on maximizing wealth in the face of a monumental market decline. The death of the longest Bull Market in history was swift, although not painless. We have had extreme volatility in both equities and fixed income; we have side-stepped the fixed income volatility for the most part. As we survey our accounts and find individual stocks down significantly, we would be well-served by implementing strategies to mitigate the impact of temporary declines, so that when security prices have recovered your tax position and net worth are enhanced.
I have listed the strategies we have identified into to two classes: “Market Related” and “Financial Planning Related”. The Market Related category revolves around either increasing equity exposure or optimizing existing equity exposure by increasing expected returns. The Financial Planning Related category discusses income tax, cash flow, and insurance related strategies to maximize after-tax net worth and to reduce distribution rates during the market decline.
Below is a summary of the strategies, and more detailed explanations follow.
Market Related Actions:
Add cash from outside accounts
Deploy excess cash
Increase the earnings yield of individual stock portfolios
Reduce credit risk and interest rate risk
Increase alternative investments
Add international exposure
Dollar-Cost-Average new mutual fund investments
Financial Planning Related Actions:
In-kind Roth IRA Conversions
Make Roth IRA/Health Savings account contributions now
Harvest losses in Non-Qualified accounts
Take gains in long-held positions that had prohibitive capital gains
Take Required Minimum Distributions (RMDs) in-kind
Delay unnecessary large expenses
Refinance your mortgage or other debt
Consider not prepaying your mortgage for a period of time and investing the excess
Exercise and Hold Stock Options instead of using cashless exercise
Evaluate and optimize Variable Life Policies
Access basis in annuities that have declined
Begin guaranteed withdrawal benefits in annuities with benefit bases significantly above the account balance
Utilize Fixed-Indexed annuities to replace bond exposure
Market Related Actions:
Add cash from outside accounts: If you are holding excess cash that is not earmarked for a specific purpose, and is not needed for living expenses, consider increasing the amount of assets available in your investment portfolio. We will not invest all of your cash at one time, we would likely suggest that you dollar-cost-average (discussed below) mutual funds, or that you scale purchases of individual securities as they decline to maximize the probability of having cash left when prices are near their lowest. There is no viable strategy to find a bottom in stocks, it will not be known until months or years later. In addition, we have many thousands of securities available, and they don’t all reach bottom on the same day. You could try to predict the bottom in the Dow Jones Industrial Average, but we don’t invest directly in the Dow, so it would have very little bearing on the prices of our securities.
Deploy excess portfolio cash: We have a tendency, based on our principles, to have large amounts of cash in our portfolios, based on each individual’s goals, constraints and risk tolerance. Now would be a good time evaluate your needs for liquidity to determine whether or not you have excess portfolio cash to invest. This should be done slowly over time, not all at once, and it is imperative that we always maintain adequate liquidity to meet your needs for living expenses for 18-24 months.
Rebalance Portfolios: Since stocks have declined and the bonds and cash that we use have remained relatively stable, now may be a good time to rebalance your portfolio to ensure that you have an adequate percentage of your portfolio in equities. As equities decline, and other securities decline less or stay the same, the percentage allocation to equities declines. This reduces potential portfolio volatility at the very time that we should be increasing it, just like failure to rebalance on the way up increases volatility when we should be reducing it. Maintaining consistent, or even increasing, exposure to equities during a market decline is likely the prudent course of action.
Increase the earnings yield of individual stock portfolios: Since we do not utilize indexing, our securities do not all fall in unison. Certain companies and sectors are punished more than others, creating an ability to increase the overall yield of the portfolio in terms of earnings by increasing exposure to companies and sectors that have declined more than others. While we will not build significant positions in individual securities in relation to your total portfolio, increasing positions that have declined inordinately can decrease the time it takes for individual positions to recover. In addition, it protects against loss in the event of a buy-out from another company near the bottom. In order for this strategy to be effective, we have to pay careful attention that the companies we increase exposure to have not deteriorated significantly in future earnings potential; this is something we are constantly monitoring.
Reduce credit risk and interest rate risk: There are two major components of fixed income risk: credit risk and interest rate risk. Credit risk is specific to the borrower and measures the likelihood that a future payment will be late or missed. Interest rate risk describes the inverse relationship between interest rates and fixed income prices and help measure how significantly an increase or decrease in general interest rates will impact the value of a fixed income investment. We had very little credit or interest rate risk heading into this decline, purposely based on the general level of interest rates, and the level of credit spreads available in non-government fixed income securities. As credit spreads widen, we may look to add exposure to credit risk back to our portfolios in the form of Floating-Rate Bonds or High Yield Bonds; but for now we wait to see how the default cycle unfolds.
Increase alternative investments: To some portfolios, where appropriate, we have been adding additional alternative investment exposure in the form of Merger Arbitrage exposure and Gold. We are not adding Private Equity and Hedge Funds at the current time, although if the dynamics of these strategies were attractive, we would. In addition, we have not added significant Real Estate exposure based on interest rates, occupancy rates, and capitalization rates.
Add international exposure: We have significantly avoided excess international exposure for several years. International exposure in some Target Date Funds has increased to as much as 40% recently. These securities declined significantly more than our average US focused mutual fund. Based on this decline, and the amount of Fiscal and Monetary stimulus about to be implemented in the United States, adding some exposure to International Stocks may be prudent in the right situation. Keep in mind this is a valuation decision, not a timing decision. Further keep in mind that system and stability of government is very important during an international crisis like this. It is possible that emerging markets governments may prevent export of certain goods, confiscate certain goods, or even seize property and facility of foreign companies, with this in mind we are limiting exposure to emerging markets securities.
Dollar-Cost-Average new mutual fund investments: Dollar-Cost-Averaging is strategy that takes advantage of fluctuating security prices. Each period (weeks or months) a fixed dollar amount of a fund is purchased on a regular basis. As prices fluctuate, more or less shares are purchased each time period. At the end of the period, assuming there has been significant downside volatility, you have the opportunity to own more shares than if you invested in a lump-sum at the beginning of the period. It also forces you to stay disciplined, prevents you from trying to time the market, and allows you to have multiple different chances to buy securities at what will someday be known as the bottom.
Financial Planning Related Actions: