In this article, I discuss a family who wants to reduce their stress. The allure of timing the equities markets has them thinking this is one way to get there, but they are taking on at least three big risks. I present a four-fold action plan that works better than market timing and is a lot less stressful, too.
Bill and Jean cannot stomach the thought that the stock market might crash. Their businesses were hurt badly by various government shutdowns due to the pandemic. They are considering changing careers. Bill recently had health issues, none of which are improved with the additional stress from an economic shutdown. Jean wants both of them to spend more time with their adult children, who are busy with their own lives and cannot visit home as often as mom and dad would like. Even though they both tested negative for COVID-19, they are full of negative feelings.
Bill and Jean are not alone with their worries. The headlines, from numerous sources, seem to beat the same drum: the market is overvalued, a correction (or crash) is imminent, etc. They would like a plan to protect their assets, just in case.
Bill and Jean face at least three big obstacles to their success: taxes, timing it twice, and increased risk and volatility.
If Bill and Jean decide to sell out of their portfolio, they will likely cause a tax problem. Investment gains in taxable accounts are taxed at either short-term or long-term capital gains tax rates. Any gains they have earned within the past 12 months will be taxed at their income-tax brackets. Today, income tax brackets are as high as 37%. Any gains they have earned on holdings they have held longer than 365 days are taxed at the long-term gains tax rates, which are as high as 23.8%, including a 3.8% net investment income tax.
Taxes can eat up a lot of those gains!
Here is another thing that happens when we sell out of investments: we may force other gains we might normally earn into higher tax brackets as well. Plus, since they are close to retirement age, Bill and Jean may be considering or already taking Medicare. The monthly cost of Medicare increases two years after a windfall year. If they sell out, then they may have to pay higher Medicare costs for two more years—until they can show a lower income. If they keep “timing the market,” they may cause themselves an ongoing or periodic problem here as well.
If Bill and Jean do experience a loss, they could sell some losers and winners at the same time. This is called “realizing” their gains/losses. This would reduce, or possibly eliminate their tax problem.
Timing it Twice
The biggest problem with attempting to pull out and protect their gains is timing. No one knows when the market is going to hit its peak. Nor do we know when it is going to bottom out. If Bill and Jean take action on their fears, they have to do two impossible things right:
- Sell high
- Buy low
While it might feel good to get out of the market now, after a recent rise and when the market is near all-time highs, often feelings pass quickly. And rarely do feelings make for good financial decisions. Think about the situation they are in. Now they are either hoping for a market decline, in which case (I guess) they would feel good. That is the best case. But even then, they are likely to feel scared because their fears were rewarded. A vicious feedback loop ensues. Let’s follow it a little further, because eventually, Bill and Jean have to make a second decision to re-invest their money.
Do they wait for a market rebound? How much of a rebound?
The best case for market timers is not that good. Emotions run high, and then they run higher. Timing the market is almost always more stressful than riding it out, even if they are lucky enough to avoid a crash. As emotionally satisfying as it might seem at first, to sell out and wait for a correction is often difficult. Even if you are successful, it still doesn’t feel good.
Plus, market timing is usually very expensive.
Increasing (not Decreasing) Risk and Volatility
A recent research report from the academics Ilia Dichev and Xin Zheng, argues that investors who time the market not only give themselves lower returns, but take on higher risks as well! In the pursuit of avoiding the next stock market crash, “investors tend to ‘chase stability’ but have bad timing, adding capital to stocks after low past volatility but before high future volatility.
This might seem counterintuitive, but it fits in with my decades-long experience helping people with their financial planning and investment decisions. The market historically comes back—and it is likely to do so again in the future. Investors who cash out may sit on the sidelines too long. They may buy into investments that have recently done well, and that is where they make another mistake. As the disclosures on every document say: “Past performance is not indicative of future performance.”
As we discussed earlier, the best case doesn’t feel that good—and it is rarely successful. Usually, the returns are not as good as market-timers anticipated. And worse, the risks are higher. So, imagine how that feels!
Here is a solution to consider instead. It is a four-fold plan.
1. Create a Financial Plan
First, Bill and Jean should start with a financial plan. A meeting with a CFP® professional will help them prioritize their values, goals and relationships. Then, they can align their money with what means the most to them. They can understand what risks they are currently taking and how much they could be affected by a stock market decline. This should bring a sense of peace and calm—a very good place from which they can make prudent financial decisions.
2. Segregate the Money into Buckets
After they have updated their financial plans, Bill and Jean can segregate their money into at least two or three (or four) buckets. They will want to start with the safe money. For any expenditures they plan on making in the next few years, they should set this money aside and keep it safe. This means that Bill and Jean must forego the potential long-term high returns on this money. Instead, they will be able to afford what they need to, when they need it, in the near future.
3. Invest for the Long Haul
With most of the rest of their funds, they should consider investing for the long haul. They will likely want the lion’s portion of this money in equities. Their financial planner will help them make an asset allocation decision that is right for them. The proceeds could include planned expenditures further into the future. Perhaps paying for their daughter’s wedding, helping the kids as they start their own families, or funding their grandchildren’s college educations.
The important success factor for a “long haul” bucket is willful ignorance—or at least ignoring it over the short haul. For this money, market timing is prohibited. This way, Bill and Jean can participate when the sudden, inexplicable, unpredictable market grows to new heights as it did in 2020, as it has in the past and will likely do again in the future. We just don’t know when. That little bit of humility goes a long way over the long haul.
4 . Create a Play Bucket
Finally, if Bill and Jean just can’t keep their eyes or hands off their long-haul money, then they should consider a new bucket of money. With this money, they allow themselves to time the market. They can make investment selections that suit their personalities. They can invest with their own best ideas. With the help of their CFP® professional, they can make sure that this bucket of money is not too large to be dangerous or too small to be meaningless.
With the help of this four-part financial planning tool, Bill and Jean can reduce the stress they feel with the equity market’s highs and lows. They will have a plan they can rely on. Second, they will have the money they need to cover the short-term costs. And third, they will have the right amount of money invested for the long haul so they can achieve their most important long-term, real-life goals. Finally, and optionally, they can create a “play bucket” if they just cannot avoid taking action on their investments.
Once Bill and Jean can set aside their investment concerns, then they will free up the emotional and intellectual energy they need to take care of all the other stressors in their lives. This is one big step toward freedom!
To find your CFP® professional, visit letsmakeaplan.org.
Karl Frank CFP®
Securities provided through Geneos Wealth Management Inc., member FINRA, SIPC. Investment advisory services offered through A & I Financial Services LLC, registered investment advisor.
This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results.
 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3663350 The Volatility of Stock Investor Returns September 3, 2020.