When markets take a dive, the last thing you want to do is sell at depressed prices—but sometimes you have no choice. A medical or tax bill could be due, or you may simply need to replenish your cash reserves.
Whatever the reason, there are ways for cash-strapped investors to minimize the impact on both their portfolios and their long-term investing goals.
“The important thing is to make strategic decisions rather than emotional ones,” says Mark Riepe, head of the Schwab Center for Financial Research. “If you don’t, you could end up locking in losses and may run the risk of permanently undermining your portfolio’s ability to recover.”
With that in mind, here are four strategies for selling in a down market.
1. Rebalance your portfolio
Periodically rebalancing your portfolio—which involves selling overweight positions and buying underweight ones to keep your portfolio in line with its target asset allocation—is a good idea in the best of times. But when the going gets tough, it can also help you make dispassionate decisions that can lead to better outcomes.
“The recent market turbulence likely threw your portfolio out of whack,” Mark says. “By refocusing on bringing your portfolio back to its target allocation, you can more easily identify those assets you’d probably want to sell anyway.” For example:
A. Imagine an investor with a $500,000 portfolio and a target allocation of 60% stocks, 35% bonds, and 5% cash investments. After a rough few months, the stock portion of his portfolio falls by $75,000:
B. At the same time, the investor needs to withdraw $15,000 from his investment portfolio to cover an unexpected bill. To figure out what to sell in order to meet his cash need, the investor should:
1. Subtract his cash need from his current portfolio balance:
|Current portfolio balance:||$425,000|
|New portfolio balance:||$410,000|
2. Use his new portfolio balance and target allocation percentages to determine his target dollar amounts for stocks, bonds, and cash investments. “Interestingly,” Mark says, “to achieve his target asset allocation, our hypothetical investor actually needs to buy more stocks—presumably at lower prices, which should work in his favor should the market turn around.” After selling overweight positions and buying underweight ones, the investor can use the remaining cash proceeds to pay his unexpected bill:
2. Take out the trash
Once you’ve figured out which asset classes to sell, it’s time to identify individual investments to offload. The place to start is holdings with weak prospects or that no longer match your goals. “If you wouldn’t consider buying more of a particular investment today, then you should seriously consider selling it,” Mark says.
To assess the merits of an exchange-traded fund or a mutual fund, check that its investment strategy still matches your goals and its recent performance is in line with your expectations.
To assess the merits of an individual stock, check out the underlying company’s earnings and balance sheet for signs of weakness—or use Schwab Equity Ratings® to get a sense of a stock’s prospects. “Don’t be sentimental,” Mark says. “Even if a stock has performed well for you in the past, that doesn’t mean it will continue to do so in the future.”
3. Harvest some losses
If you need to sell more after offloading investments that no longer match your goals, it’s time to realize some losses.
Selling for a loss is never easy, but sometimes it can actually work in your favor. That’s because you can use those losses to offset gains you may have realized in your taxable accounts over the course of the year, which can help reduce your tax liability—a strategy known as tax-loss harvesting (see “Using a tax loss to get a tax break,” below).
Using a tax loss to get a tax break
A hypothetical investor who realized $10,000 in short-term capital gains and $15,000 in capital losses could use tax-loss harvesting to cut down her tax bill.
Source: Schwab Center for Financial Research. Assumes a 32% combined federal/state marginal income tax bracket, with short-term capital gains taxed at ordinary income tax rates. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product and the example does not reflect the effects of fees.
Even if you have no gains to counteract, you can still use your losses to offset up to $3,000 of ordinary income per tax year until all your losses have been accounted for.
If the proceeds from harvesting losses exceed your cash needs, you should reinvest the money in holdings that match your target asset allocation and show promising future prospects. Just be sure you don’t violate the so-called wash-sale rule by repurchasing the same or “substantially identical” securities within 30 days before or after a sale, lest your losses be disallowed.
4. Be tax smart
If, after harvesting all your losses, you still need to sell assets to meet your cash needs, be sure to make tax-efficient choices. For example, consider selling investments you’ve held for more than a year. Any gains on stocks, bonds, and mutual funds held for more than one year are taxed at a maximum federal long-term capital gains rate of 20%, whereas investments held for a year or less are taxed at your federal ordinary income tax rate.
In an ideal world, these steps would be part of your regular portfolio maintenance. If the recent volatility exposed flaws in that routine, now’s a great time to do some proactive planning so you’re better prepared next time. In particular, you should remain vigilant about maintaining an asset allocation that’s appropriate, given your time frame and goals (see “Choosing the right allocation for you,” below).
“The right portfolio allocation isn’t just about your emotional tolerance for big price swings,” Mark says. “It’s about your time horizon: Can you afford to wait out a big loss?”
That’s one reason Schwab recommends individuals who are nearing or in retirement have enough cash on hand to cover at least a year’s worth of expenses—plus another two to four years’ worth of cash in a relatively liquid investment like a certificate of deposit or short-term bond fund.
“If you have enough short-term cash reserves stored up, you can avoid selling during a downturn altogether,” Mark says. “Nobody wants to buy high and sell low—and with a little planning, you may never have to.”