Volatility: We’ve Been To This Barbeque Before

In addition to the human tragedy, the serious situation in Ukraine certainly gives many investors cause for consternation, particularly those who have been in the market 10 years or less. However, history tells us that not only is volatility normal, but volatility can create opportunities, since some loss-averse investors will make a beeline for the exits. Consider some of the following geopolitical events from 1973 – 2014 and their accompanying market volatility, illustrated by this chart from JP Morgan:

Within these observations, note the average duration of the sell-off was 12 days, with some (Egypt/Arab Spring) being as short as 2 days and the Israel/Arab war and OPEC oil embargo lasting 27 days. Note that other than one conspicuous outlier (the 1973 oil shock), the sell-offs were over rather quickly, for an average of about 16 days to recover to the prior level (excluding 1973). Thus, in most geopolitical events in recent history, we’ve seen the market undergo a quick sell-off and a quick turnaround.

Angela Robinson, CRC®, CFP® from Kennedy Financial Services, offers an interesting approach focused on the longer-term time horizon. In her March 7, 2022 post entitled ’89 Reasons Why Not to Invest in the Stock Market’, Robinson examines a plethora of woes from the Great Depression and Spanish Civil War to the beginning of the Cold War, the Cuban Missile Crisis, and the 1973 Energy Crisis to Covid 19. All 89 events are chilling, and taken together, they paint a rather gloomy picture. In contrast, Robinson points out that had you invested $10,000 in the S&P 500 Index on January 1, 1934, by 12/31/2021 you’d have $100,621,126. We suppose you’d presume it was invested in some charitable perpetuity since there no tax friction, nor estate friction. To provide additional context, Robinson offers a realistic example of $10,000 invested on January 1, 1981, which would have compounded to $963,427 and change.

The moral of both stories? Historically, markets experience a sell off on bad news and recover when the bad new turns out to be ‘less bad’ than the direst predictions. It could be called the ‘optimism bias’, where investing in larger asset classes have extraordinary upside (for the survivors) and limited downside (for the losers). In other words, a stock can only go down 100% (which is very painful) but can go up 3,641,613% from 1964 -2021 like Berkshire Hathaway (according to their annual letter).

This brings us to the question: what to do?

Rebalance. Rebalancing a portfolio in a volatile market is a well-established risk-reduction technique. Rebalancing sells the asset classes that are proportionately high and buys those that are proportionately low. If the stocks have dropped, rebalancing buys more stocks. Rebalancing can be the whole portfolio recipe (strategic rebalance) or just a few asset classes (tactical rebalance). Investors in a tax-deferred account like a 401(k) can use their contributions to rebalance. Thus, an investor might direct current contributions to equities if they felt equities were low. Rebalancing is simpler in tax-deferred and tax-free accounts since there is no tax friction from the trades.

Harvest Losses and Swap. A simple idea for taxable accounts is to harvest losses. If your account has a fund or stock that is at a loss, sell the security and either wait 31 days to replace it, or buy something very similar, but not identical. An example might be if an investor had technology stocks that were hit hard by the recent events, they could sell those at a loss and buy something like the XLK, which is an ETF that buys the tech sector. The ‘Wash Sale’ rule disallows deducting a loss on the sale of securities if the investor buys the same or a substantially identical security within 30 days before or after the sale. You can’t wash index funds, like swap an S&P 500 index fund for another S&P 500 index fund, but you can clearly swap a S&P 500 index fund for a total market index fund or ETF. You also can’t wash sales in different accounts like sell in a taxable account and buy in a Roth IRA.

With crypto, there is no wash sale rule. Thus, you can sell Bitcoin today, buy it back today and deduct the loss. Remember the rule about capital loss deductions: you first net all capital losses against capital gains (long-term and short-term), and then can deduct from the net losses up to $3,000 a year from your income and carry the unused losses over to future years.

Roth Conversions or Contributions. An obvious strategy is to build up Roth assets in a down market, whether using contributions to a Roth IRA or Roth 401(k), or converting an existing IRA to a Roth. A conversion offers more firepower since you can determine the amount to optimize the Roth, and even the assets. Remember you pay taxes on the conversion, so it is important to weigh the tax ramifications. A strategy sometimes employed with a Roth conversion is a ‘Roth Charity Offset’, where you convert to a Roth in a down market, and make an offsetting charitable donation, usually out of appreciated assets later in the year to offset the income from the Roth conversion. Note that there are AGI limits on the deductibility of charitable contributions as well as the limit on the standard deduction.

Bottom Line. There a have been 89 (and probably more) reasons to be out of the markets, all of which eventually turned out to be less impactful in the long run. Geopolitical events, while unsettling, can be viewed as an opportunity or a threat. We’ve been to this barbeque before, its just that the brisket is different his time. As always, I’ll try to answer e-mailed questions, so reach out at llabrecque@sequoia-financial.com.