Investing involves navigating volatile markets. This blog will highlight three investment strategies investors can employ during volatile markets to help improve investment outcomes. This is a follow-up to our earlier blog about developing a resilient investment plan for volatile markets.

In The Psychology of Money, Morgan Housel declares, “The price of investing is volatility, fear, doubt, uncertainty, and regret.” I love the way he frames volatility. And it is entirely accurate, as investors, we should understand that if our investment can increase dramatically for our benefit, there must be a chance it can also decrease just as dramatically. It is the double edge sword of equity ownership.

We often talk to our clients about having a “bear market playbook,” a plan to navigate those unexpected market selloffs. For each investor, that playbook will look a little different. People may be targeting different buying opportunities based on their financial goals or investment preferences. Regardless of the opportunities, you seek during selloffs, the three strategies to navigate volatile markets are Dollar-Cost Average, Tax Loss Harvesting and Roth Conversions. Let’s take a look at each one.

Dollar Cost Averaging

Dollar-cost averaging is an excellent way for investors of all ages and asset levels to build wealth. It is the most straightforward way to ensure investment success in all market environments. During periods of volatility, this strategy excels.

Dollar-cost averaging is the act of investing the same amount of money into the market at regular intervals. Anyone who is contributing to a 401k is already dollar-cost averaging. With each paycheck, the same set amount is invested in your 401k. Because the same amount of money is invested at each interval, the number of shares or units of investment will vary. When the asset has depreciated, more shares are purchased. When the asset’s price has increased, fewer shares are purchased. Because more shares are purchased when the cost is lower, the average cost per share will decrease over time. 

This strategy also eliminates the opportunity for bad investor behavior. Studies show that when investors attempt to time the market, they often miss and underperform the market. The regular schedule or, better yet, automated investing ensures investors avoid this common pitfall. 

Tax Loss Harvesting

Tax-loss harvesting is often a strategy used close to the end of the year to reduce portfolio taxes. However, a savvy investor can use this strategy to capture losses when markets are volatile at any time of the year.

With tax-loss harvesting, an investment that has an unrealized loss is sold. The portfolio retains a tax credit that can be applied against any realized gains in the portfolio. The sold asset is replaced with a similar asset to maintain the desired portfolio allocation. There are some nuances investors need to be aware of to avoid violating the “Wash Sale Rule,” which can eliminate the tax benefits and purpose of this strategy.

Investors can use portfolio losses in two ways. First, they can offset an unlimited amount of capital gains in the portfolio. After neutralizing all portfolio gains, up to $3,000 of portfolio losses can offset ordinary income. That dual use of the losses helps manage near-term tax liabilities and increases investors’ after-tax returns.

Tax-loss harvesting creates what we call “tax-alpha,” this is the total portfolio gain in a tax-smart invested portfolio compared to the same portfolio without tax-loss harvesting.

Roth Conversion

Volatile markets offer investors a unique opportunity to execute Roth Conversions as part of their retirement and tax strategy. Converting a temporarily depreciated portfolio lowers the taxes due at year-end. Tax-savvy investors can convert more assets within the same tax budget or convert assets at a lower tax cost.  

The benefit of the conversion in the long term is significant. The investor lowers their tax bracket in retirement and extends portfolio longevity. The converted assets will continue to grow uninterrupted by Required Minimum Distributions, and distributions will not be subject to tax.

Concluding Thoughts

Most people talk and think about numbers and dollars when it comes to investing. The reality is investing can be very emotional, and managing down markets or bouts of market volatility tests those emotions. Investors should have a plan for managing volatility. These three strategies should be cornerstones of your portfolio management when markets misbehave.

Dollar-cost averaging is practical and straightforward to implement at all wealth levels. For investors looking to add tax-loss harvesting to their ongoing investment management, it is best to work with an advisor who can also have tax planning conversations. The same is true for people considering Roth conversions. They will want to have their tax advisor and investment advisor working in concert to ensure they achieve the optimal outcome.

Pleasant Street Wealth Advisors is on a mission to give our clients confidence in their financial life to spend more time on the things they enjoy. We want our clients to have peace of mind when it comes to their investments. Enjoying life and not worrying if their portfolio went up or down today. If you are looking for that confidence and peace of mind, schedule a meeting with us. We would love to show you how we serve our clients!