Dear Family, Friends, and Clients:
While our fellow investors lament the state of the market, we will focus our time on maximizing wealth in the face of a monumental market decline. The death of the longest Bull Market in history was swift, although not painless. We have had extreme volatility in both equities and fixed income; we have side-stepped the fixed income volatility for the most part. As we survey our accounts and find individual stocks down significantly, we would be well-served by implementing strategies to mitigate the impact of temporary declines, so that when security prices have recovered your tax position and net worth are enhanced.
I have listed the strategies we have identified into to two classes: “Market Related” and “Financial Planning Related”. The Market Related category revolves around either increasing equity exposure or optimizing existing equity exposure by increasing expected returns. The Financial Planning Related category discusses income tax, cash flow, and insurance related strategies to maximize after-tax net worth and to reduce distribution rates during the market decline.
Below is a summary of the strategies, and more detailed explanations follow.
Market Related Actions:
- Add cash from outside accounts
- Deploy excess cash
- Rebalance Portfolios
- Increase the earnings yield of individual stock portfolios
- Reduce credit risk and interest rate risk
- Increase alternative investments
- Add international exposure
- Dollar-Cost-Average new mutual fund investments
Financial Planning Related Actions:
- In-kind Roth IRA Conversions
- Make Roth IRA/Health Savings account contributions now
- Harvest losses in Non-Qualified accounts
- Take gains in long-held positions that had prohibitive capital gains
- Take Required Minimum Distributions (RMDs) in-kind
- Delay unnecessary large expenses
- Refinance your mortgage or other debt
- Consider not prepaying your mortgage for a period of time and investing the excess
- Exercise and Hold Stock Options instead of using cashless exercise
- Evaluate and optimize Variable Life Policies
- Access basis in annuities that have declined
- Begin guaranteed withdrawal benefits in annuities with benefit bases significantly above the account balance
- Utilize Fixed-Indexed annuities to replace bond exposure
Market Related Actions-
- Add cash from outside accounts: If you are holding excess cash that is not earmarked for a specific purpose, and is not needed for living expenses, consider increasing the amount of assets available in your investment portfolio. We will not invest all of your cash at one time, we would likely suggest that you dollar-cost-average (discussed below) mutual funds, or that you scale purchases of individual securities as they decline to maximize the probability of having cash left when prices are near their lowest. There is no viable strategy to find a bottom in stocks, it will not be known until months or years later. In addition, we have many thousands of securities available, and they don’t all reach bottom on the same day. You could try to predict the bottom in the Dow Jones Industrial Average, but we don’t invest directly in the Dow, so it would have very little bearing on the prices of our securities.
- Deploy excess portfolio cash: We have a tendency, based on our principles, to have large amounts of cash in our portfolios, based on each individual’s goals, constraints and risk tolerance. Now would be a good time evaluate your needs for liquidity to determine whether or not you have excess portfolio cash to invest. This should be done slowly over time, not all at once, and it is imperative that we always maintain adequate liquidity to meet your needs for living expenses for 18-24 months.
- Rebalance Portfolios: Since stocks have declined and the bonds and cash that we use have remained relatively stable, now may be a good time to rebalance your portfolio to ensure that you have an adequate percentage of your portfolio in equities. As equities decline, and other securities decline less or stay the same, the percentage allocation to equities declines. This reduces potential portfolio volatility at the very time that we should be increasing it, just like failure to rebalance on the way up increases volatility when we should be reducing it. Maintaining consistent, or even increasing, exposure to equities during a market decline is likely the prudent course of action.
- Increase the earnings yield of individual stock portfolios: Since we do not utilize indexing, our securities do not all fall in unison. Certain companies and sectors are punished more than others, creating an ability to increase the overall yield of the portfolio in terms of earnings by increasing exposure to companies and sectors that have declined more than others. While we will not build significant positions in individual securities in relation to your total portfolio, increasing positions that have declined inordinately can decrease the time it takes for individual positions to recover. In addition, it protects against loss in the event of a buy-out from another company near the bottom. In order for this strategy to be effective, we have to pay careful attention that the companies we increase exposure to have not deteriorated significantly in future earnings potential; this is something we are constantly monitoring.
- Reduce credit risk and interest rate risk: There are two major components of fixed income risk: credit risk and interest rate risk. Credit risk is specific to the borrower and measures the likelihood that a future payment will be late or missed. Interest rate risk describes the inverse relationship between interest rates and fixed income prices and help measure how significantly an increase or decrease in general interest rates will impact the value of a fixed income investment. We had very little credit or interest rate risk heading into this decline, purposely based on the general level of interest rates, and the level of credit spreads available in non-government fixed income securities. As credit spreads widen, we may look to add exposure to credit risk back to our portfolios in the form of Floating-Rate Bonds or High Yield Bonds; but for now we wait to see how the default cycle unfolds.
- Increase alternative investments: To some portfolios, where appropriate, we have been adding additional alternative investment exposure in the form of Merger Arbitrage exposure and Gold. We are not adding Private Equity and Hedge Funds at the current time, although if the dynamics of these strategies were attractive, we would. In addition, we have not added significant Real Estate exposure based on interest rates, occupancy rates, and capitalization rates.
- Add international exposure: We have significantly avoided excess international exposure for several years. International exposure in some Target Date Funds has increased to as much as 40% recently. These securities declined significantly more than our average US focused mutual fund. Based on this decline, and the amount of Fiscal and Monetary stimulus about to be implemented in the United States, adding some exposure to International Stocks may be prudent in the right situation. Keep in mind this is a valuation decision, not a timing decision. Further keep in mind that system and stability of government is very important during an international crisis like this. It is possible that emerging markets governments may prevent export of certain goods, confiscate certain goods, or even seize property and facility of foreign companies, with this in mind we are limiting exposure to emerging markets securities.
- Dollar-Cost-Average new mutual fund investments: Dollar-Cost-Averaging is strategy that takes advantage of fluctuating security prices. Each period (weeks or months) a fixed dollar amount of a fund is purchased on a regular basis. As prices fluctuate, more or less shares are purchased each time period. At the end of the period, assuming there has been significant downside volatility, you have the opportunity to own more shares than if you invested in a lump-sum at the beginning of the period. It also forces you to stay disciplined, prevents you from trying to time the market, and allows you to have multiple different chances to buy securities at what will someday be known as the bottom.
Financial Planning Related Actions:
- In-kind Roth IRA Conversions: A Roth Conversion is a voluntary transfer from a Traditional (pre-tax) IRA to a Roth (after-tax) IRA. Taxes are paid on the transfer amount either in your quarterly tax estimates or when you file the next year. This strategy is most effective if the taxes are paid from outside of the IRA. A conversion can be in either cash or securities. Electing to transfer securities that have declined significantly and paying taxes on the reduced amount, gives you the opportunity to take advantage of tax-free growth on the recovery. Each situation will be different, so it is important to work with your Wealth Advisor on determining the opportunity in using this strategy.
- Make Roth IRA/Health Savings account contributions now: If you plan to make contributions to your Roth IRA or HSA for this year, consider making the contribution earlier, while security prices are still declining. While there is no way to know if we are at the bottom, we can say with confidence that we are significantly lower than last month, and that equities are offering a much higher implied future return.
- Harvest losses in Non-Qualified accounts: Taking advantage of tax losses between now and the end of the year will allow you to offset capital gains distributions from mutual funds at year end. Typically, when the market declines significantly, funds must sell investments to create additional liquidity, so in the past mutual fund distributions have been high in years where markets are down. In addition, you can use excess capital losses to offset $3,000 in ordinary income and carry-forward unused losses above this level.
- Take gains in long-held positions that had prohibitive capital gains: If you have non-qualified securities that you have been holding for a long-time simply because of the embedded capital gains, now may be an opportune time to take the lower gain and move to a more optimal investment with better potential future returns. In addition, if you have concentrated stock positions, now may be a good opportunity to trim exposure either because the price of your concentrated position is down, or because you have other losses available to offset the gains.
- Take Required Minimum Distributions (RMDs) in-kind: Although RMDs have been suspended for this year, you may still elect to take your distribution to reduce future distributions, and you may elect to take the distribution in-kind, instead of in cash. If you have securities that are down significantly, you may distribute them to your non-qualified account and take advantage of capital gains on the recovery. Since RMDs have been suspended, this strategy is most effective for clients who have little existing non-qualified money with which to pay taxes on Roth IRA Conversions.
- Delay unnecessary large expenses: Since we are managing your goals for a lifetime, if you have discretionary purchases like a new car, boat, or vacation property that could wait until the market recovers, this may be a prudent course of action at this time. Work with your Wealth Advisor to determine the necessity of delaying large expenditures based on your individual goals, constraints, risk tolerance and distribution rate.
- Refinance your mortgage or other debt: Consider evaluating your liabilities to determine whether or not refinancing or consolidating would reduce your monthly payments. This is an especially opportune time if there is any anticipation of being unemployed in the future. Evaluate the possible reduction in monthly payment, future interest cost, and closing costs required to fund the new mortgage.
- Consider not prepaying your mortgage for a period of time and investing the excess: If you are currently making excess payments on a low interest mortgage, consider redirecting the excess to your investment account and dollar-cost-averaging into equity funds over time. Since expected future returns have increased significantly, the future return on investments may greatly exceed the financing costs on current mortgages. While we would never recommend taking additional debt to fund investments, reducing prepayments and redirecting to investment accounts may be a very profitable strategy in this environment.
- Exercise and Hold Stock Options instead of using cashless exercise: If you have stock options that are close to expiration, Exercise and Hold may be a superior option to cashless exercise. Work with your Wealth Advisor for further exploration.
- Evaluate and optimize Variable Life Policies: Owners of Variable Life policies should at minimum request reprojections of policies to make sure that they are not impaired by the market decline. If life policies are impaired alternatives include reducing death benefits, adding additional premiums, 1035 exchange to an annuity, or full surrender. Your Wealth Advisor can help you make the optimal decision.
- Access basis in annuities that have declined: If you have non-qualified annuities that have large embedded gains, now may be an opportune time to take distributions and possibly access basis. Non-qualified annuities are “Last-in/First-Out” (LIFO) accounting, which means all gains must be removed before accessing principal. If your embedded gains have declined significantly, you may have an opportunity to get to principal that has been trapped by prohibitive gains.
- Begin guaranteed withdrawal benefits in annuities with benefit bases significantly above the account balance: If you have annuities with guaranteed withdrawal benefits, now may be a good time to start the available income if your “benefit base” is significantly higher than your surrender amount. Guaranteed income is a lifetime benefit, and if it looks unlikely that your surrender value will ever surpass your benefit base you may be better off taking the income now. Work with your Wealth Advisor to run calculations.
- Utilize Fixed-Indexed annuities to replace bond exposure: While fixed-indexed annuities are a bad word in some circles, our position as a fiduciary allows us to offer highly efficient “fee-only” annuities that are able to pass on increased benefits due to the removal of commissions. In some cases, a cap of 5-7% may be available based on the performance of an index like the S&P 500, which is currently at a much lower level than last month. The principal amount is guaranteed and the worst-case scenario in a market decline is an annual return of 0. In a market where floating-rate, high yield, emerging market and even some government bonds are down 10-20%, zero looks like a decent return.
We do not frequently produce a list of possible strategies distributed on a wide scale. Each of these opportunities is case specific and requires interaction with your Wealth Advisor to run calculations and determine appropriateness, but this is the work we are doing now while the market continues to be volatile. We continue to manage your recommendations based on your lifetime, instead of for just the next quarter. Vladimir Ilyich Lenin said, “There are decades where nothing happens; and there are weeks where decades happen”, this may be one such time period where the latter is true. It is important that we act efficiently and quickly but not rashly and randomly.
We will continue to diligently monitor investment markets and your accounts to help you maximize your lifetime wealth. We will also implement our financial planning strategies to focus not just on what you make, but especially on what you keep. Please do not hesitate to contact your Wealth Advisor, or me personally with questions. In many cases we have been handed lemons, so how about we make some lemonade and enjoy it in the shade?