If you find yourself watching the financial headlines and getting that “Here I go again…” feeling, remember, you have lived through it before and you will live through it again. We know that declines are expected to happen and although we do not know when they will occur, they are built into our planning and portfolio design. You recovered from the tech bubble by employing sound investment practices. You followed our cash flow reserve strategy, rebalanced and recovered. After 2008, you recovered from the Great Recession, again by employing sound investment practices. You followed our cash flow reserve strategy, rebalanced, harvested losses and recovered. Then in 2020, just when we thought we might have been getting comfortable with the idea of navigating down markets, the entire world shut down for a global pandemic, markets fell precipitously and many predicted it would take years to recover! We rebalanced, bought equity, harvested losses and capitalized on what turned out to be a swift recovery from Covid fear-driven market declines. That just about brings us up to date, as we navigate another market decline with economic uncertainty on the horizon, fears of recession and seemingly unrelenting inflation.

We know it is difficult to watch the volatility day to day! Sometimes it is harder to remember that your investment portfolio is long-term money meant to last for at least the duration of your lifetime. You are in good hands with an effective cash flow reserve strategy aimed at avoiding having to sell equities at depressed prices. You are also poised to make the most of these difficult market conditions by rebalancing and harvesting losses, sometimes called tax trading.

Rebalancing

Rebalancing is essentially buying or selling pieces of the portfolio in order to bring them back to or close to their original target allocation. Like many areas of investing, the science is met with art. While there is no one “right” way to establish rebalancing parameters for a portfolio, the goal is to arrive at parameters wide enough to let markets run before taking action, but narrow enough to keep the portfolio within a specified risk/return range. Rebalance too frequently and you may end up with unnecessary taxes and transaction costs, curtail positive returns in a rising market or even “catch a falling knife” in a declining market. Rebalance too infrequently and you may end up with an allocation to equities and fixed income that differs substantially from your target allocation and may not be appropriate for your risk/return needs. In short, rebalancing ensures participation in the eventual market recovery with an appropriate allocation, rather than in a reduced capacity.

During volatile years like 2008 and 2020 (and of course in 2022…a work in progress), the equity portion of a portfolio declined relative to its fixed income portion. Suppose a portfolio that began a down year with 60% equities and 40% fixed income contained only 46% equities and 54% fixed income at the end of the year. Failing to rebalance this portfolio and return the equity allocation to 60% would result in muted participation in recovery and impaired ability to return to its previous value and beyond. You may remember the sudden recovery that began in March of 2009 amidst rampant news of bank failures and financial pundits claiming the death of long-term investing. There was certainly nothing I observed that suggested we were suddenly out of the woods! It happened again in mid-2020 while many were forecasting years of economic carnage from shutdowns, etc.

Back in 2009, we deployed a proprietary rebalancing engine that greatly improved our process for monitoring and rebalancing portfolios. Our rebalancing software has evolved over the years and it remains a sophisticated extension of our core philosophical beliefs as it allows us to combine the collective intellectual capital of our Investment Committee with the individual constraints and nuances of a specific client portfolio. It is challenging times like our current inflationary environment that present the best opportunities to actually do what we know we all want to do – buy low and sell high. We buy low when it probably feels the most miserable and sell high when we might otherwise never consider doing so!

Rebalancing during peaks and valleys in the markets can potentially improve portfolio returns by acquiring more shares at low prices and selling off shares at higher prices. Our discipline allows us to maintain a practical and systematic approach to rebalancing while minimizing the effects of behavioral biases. As evidenced by the periods of volatility throughout the last decade and a half (and indeed the last month and a half!), it is impossible to know which way the markets are going on a short-term basis. It may look obvious in hindsight, but ask yourself where the market will be next week? Next month? Or next year? Ask how many short-term traders had identified March 9, 2009, as the bottom. If anyone got it right that day, it was likely the accidental result of a random guess!

Loss Harvesting

In addition to disciplined rebalancing, tax loss harvesting is another aspect of our portfolio management process designed to add value while stewarding our clients through volatile markets. For many investors, tax loss harvesting is an important tool for reducing taxes now and in the future.  

However, tax loss harvesting is not as simple as just selling losers and banking the losses. IRS regulations discourage taxpayers from making trades for the sole purpose of avoiding taxes through the “Wash Sale Rule.” This Rule disallows a loss deduction from the sale of a security if a “substantially identical security” is purchased within 30 days before and after the date of sale.

An investor may avoid triggering the “Wash Sale Rule” and preserve market exposure by immediately purchasing a similar but not identical, highly correlated security as a placeholder.  Correlation is the statistical measure of how two securities move in relation to each other. In short, highly correlated investments can be expected to move up and down together in the market. Therefore, a highly correlated placeholder is likely to preserve the same market exposure as the investment being sold.

For example, in the case where an investor seeks to harvest a loss in the Russell 3000 ETF (IWV) and preserve exposure to the broad U.S. market, the investor could purchase the similar but not identical Vanguard Total Index ETF (VTI) to maintain market exposure without triggering the “Wash Sale Rule.” The investor could then either retain the VTI shares or sell them and repurchase IWV 31 days from the trade date where the loss was harvested.

How does this work? Here’s an example:

-You have an investment that you originally purchased for $100,000.

-Today it’s worth $70,000.

-If you sell, you will realize a $30,000 capital loss.

In reporting your taxable income for the year, you may use that loss to reduce any short and/or long-term capital gains you may have realized. Ignoring surcharges, for someone in a 32% tax bracket with $30,000 in short-term gains, that could mean a $9,600 tax savings and for someone with a $30,000 long-term gain, that could mean a $4,500-$6,000 tax savings. If the investor has realized less than $30,000 in current gains, the realized losses can be “carried forward” to offset against gains in future years.

A more detailed example follows:

Capital Gain Taxes – A Brief Primer

Almost everything you own for personal investment is a capital asset. The sale of these capital assets gives rise to capital gains and losses. Capital gains and losses are divided into long-term and short-term categories, depending on how long you have held the asset. Assets held one year or less are short-term. Assets held for more than one year are long-term. All capital gains and losses in a tax year are aggregated through a netting process to determine your net capital gain or loss for the year. If you have a net loss, it can be used to offset up to $3,000 of ordinary income in a given year. Any net loss over $3,000 can be carried forward indefinitely to offset future capital gains and up to $3,000 of ordinary income in a given year until exhausted. The netting process can quickly become confusing and its intricacies are beyond the scope of this article. The visual example that follows is simplistic and designed to emphasize the present and future benefits of loss harvesting within portfolio management.

As investors, we all know intellectually that markets will recover eventually and achieve new all-time highs. While we await those better times, we remain committed to our core discipline and to utilizing techniques like rebalancing and tax loss harvesting where they may add value.