Taking advantage of sudden lower valuations
As the stock market has reached all-time highs, it may have crossed your mind about getting in the game or even grabbing your share during market pullbacks. Beware as investment decisions during periods like this are challenging because the biggest enemies in money management – fear and greed – influence your decisions at times like these.
With a bull market now into its tenth year despite frequent threats of a looming correction, how can you avoid making rash decisions amid market highs?
First, notice I did not write market tops. Only one new market high price, identified only in hindsight, is a market peak. Markets occasionally run past their previous highs. Even if company profit growth slows down – providing less real justification for growing prices – momentum-oriented investors often keep driving stock prices higher, until it becomes apparent that markets have gone too far and the prices drop.
It is not a worthwhile exercise to gamble with short-term market movement. There are wise investing principles that you can apply effectively, especially when rising markets tempt you to deviate from your long-term plan:
Write down your strategy. Whether you are accumulating assets or spending your savings, you should define your investment approach with a written Investment Policy Statement (IPS). This is a common practice that disciplined investors use who are serious about keeping their money aligned with their goals. An investment policy should include:
The objective goal of the account.
Target allocation of the portfolio, the percentage of stocks, bonds, cash, etc.
The expected returns of the portfolio and downside risk.
How will the portfolio be measured – what relevant benchmark will be used for comparison.
When evaluating investment progress with an IPS, you know when your holdings should be rebalanced back to the target levels that you're comfortable with, based on the level of risk and return characteristics. A written policy reminds you to counter the manias and panics of the market peaks and valleys, and it's there to guide decisions beyond a buy-and-hope investment strategy.
Dollar Cost Averaging. Buy low and sell high - If only it was that easy to identify the perfect opportunities. If you have a lump sum of cash that you to invest, spreading your purchases out over time is an investment strategy to consider. Rather than trying to time the market, systematically investing a fixed amount over a period of time can remove the emotional aspects. For example, instead of investing $30,000 all at once, this can be broken down into six $5,000 purchases over the next 6 months. By doing this your total purchase price will be "averaged" based on the market prices of each of those six contributions. Dollar cost averaging does not provide any guarantees that your results will be better, but it helps spread out your purchase prices especially during times of volatility.
Diversify. It's important to broaden your investments so that they are not all correlated and don't go up and down in unison. For example, if U.S. stocks don’t appear to be on sale, international stocks may be trading at more attractive values. If your rebalance suggests that you need to take from stocks and add to bonds, consider diversifying beyond typical bond holdings. Add floating rate bonds, convertible bonds, which have stock and bond characteristics, or foreign bonds.
Rebalance. When rebalancing your assets, you sell some of your winners that have exceeded their target percentage of the portfolio and use the proceeds to buy some of the laggards whose weightings are less than your targets.
It can be tempting to let your winners keep running. Cutting off a rally short of its peak is a common concern but rebalancing doesn’t call for moving out of your investments. While some individual holdings may be outperforming the market as a whole, they won’t outperform persistently. Adjusting the size of any particular holding back to its target weighting is a prudent risk management strategy.
Selling might create capital gains taxes if the investments are outside of a retirement account, but don’t let the tax tail wag the investment dog.
Tax-loss harvesting. This is a strategy used in taxable accounts where your realized gains are offset by your losses. This helps to reduce the embedded gains in the portfolio and ultimately the potential taxes that are realized.
Taxes matter, but realizing your gains matters more. You’ll be a happy investor when you get to use those gains toward your goals and life experiences.
Investing is a disciplined process. Whether it is bull market or bear market, discipline and defined goals should lead your decisions – not fear and greed. If you find it difficult to adopt and follow a systematic investment plan, then let's review and discuss your situation.