The COVID-19 pandemic has caused a great deal of economic distress throughout the U.S., including major declines in the broad-based stock market indexes like the S&P 500. That index started tumbling in early March and reached bear market territory shortly afterward. (A bear market is defined as 20 percent or lower from market highs.)
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COVID-19 Is Not Good News for the Stock Market
While the broad stock market averages have risen since March, continuing COVID-19-related market volatility going forward can’t be ruled out. Why? First, many businesses are still shuttered and many industries are still reckoning with the overall effects of business and sector closings.
Second, many U.S. businesses and consumers don’t have their full purchasing strength for goods and services due to COVID-19 layoffs and closings. Until their return to strength, businesses that rely on them may not be able to regain their former financial footing. Third, flare-ups of COVID-19 can’t be ruled out in the future. Some observers think it may come back in the Fall, as history shows former pandemics did.
As a result, we may see curtailed businesses, weak consumer demand and spending, and even bankruptcies going forward. None of these elements are good news for the stock market. Neither is the uncertainty caused by the movement of COVID-19 itself as an illness.
How Should You Manage Your Finances?
Many people are wondering what they should do with their stock market investments and retirement funds in equities as a result. Here are strategies to consider:
The first strategy is to stay invested in your current stock market allocations.
While COVID-19 is highly unusual – a pandemic hasn’t affected global markets for more than 100 years – numerous factors can cause stock markets to fluctuate. Bear markets may be unpleasant, but they’re entirely normal and expectable.
The fact is, the S&P 500 returned 10 percent on average yearly between 1926 and 2014, and that’s including bear markets.
As a result, the primary argument for staying invested is that you’ll very likely participate in a potential upside, especially if you have 15 or more years of stock market investing ahead of you.
Timing the market has never worked. At Financial Freedom Fee-Only Wealth Management, we have never used that as an investment strategy. No one can accurately forecast when markets will fall and rise, or if. The fact that markets have just declined is not evidence that they will turn around or continue falling. If you decide to stay invested, the key is choosing investments with good economic fundamentals and being comfortable with your overall asset allocation (i.e. risk tolerance).
Prioritize Protecting the Downside
The second strategy is to prioritize protecting your investment and retirement funds from potential stock market downside. This would mean shifting some of your equity allocation to allocations in cash instruments such as certificates of deposit (CDs). CDs offer less of an average return than the stock market, but the principal does not fluctuate.
What are the reasons for potentially considering an equity reduction?
The first is simply the reduction of emotional stress. Many people may find it hard to sleep or fully relax about the prospect of their portfolios declining significantly. Emotional and sleep comfort levels are important!
The certainty of CDs for some period of time (90 to 120 days?) might do a great deal to restore your peace of mind. It’s important to keep in mind that this strategy is likely a temporary strategy and you would likely want to reinvest in equities once you’re more comfortable that the market has stabilized.
What are the financial considerations here? Let’s assume that you have a $1,268,000 portfolio. Let’s further assume we sold $814,000 of equities with no capital gains. If we assume that the market did decline 25 percent in the next 90-120 days, that would be a short-term loss in equity value of $200,000. We assume that it would be recovered over some unknown period of time. Selling $814,000 and placing it in CDs would, in other words, protect against losses of roughly $200,000 if the market drops 25 percent.
We could certainly sell more equities in that hypothetical portfolio. In case of a major market reduction, the trade-off would be between the capital gains tax bill versus the added protection of additional principal in CDs.
If you sold all of the $1,268,000 in equities, and the market dropped 25 percent, that would protect against a portfolio decline of $317,000. But you would also be facing a capital gains tax bill of approximately $52,000.
In deciding between these two strategies, you need to consider whether, on balance, you’d prefer to protect against the downside or stay invested and participate in a potential upside, especially if you have a 15- to 20-year or more time horizon.
Your Age as a Factor in Portfolio Allocation
While comfort level and preserving capital is an important factor in overall portfolio allocations, so is your age – as is reflected in a 15- to 20-year or more time horizon here.
Many portfolios are divided between stocks and cash instruments/bonds, to harness the benefits of both while at the same time protecting against the drawbacks of both. Simply put, stocks likely offer higher potential appreciation but also fluctuation of principal and volatility, including downturns. Cash and bonds offer stability, but also likely provide lower returns.
One strategy is to place proportionally more in stocks when you are relatively young, to gain the higher potential stock appreciation over time, and then to gradually increase cash/bonds as you get older.
As people plan for and approach retirement, it becomes that much more important to consider protecting their principal with proportionally more cash/bonds allocations, so their retirement plans aren’t upended by bear markets.
Decisions about how to manage your finances during the COVID-19 crisis are complex. At Financial Freedom Fee-Only Wealth Management, we understand what’s truly important to our clients and construct comprehensive wealth management plans that will help guide them toward financial security and independence. Contact us today for a complimentary consultation.