What, How and Why? Most of our conversations with you in the past two months have centered on one or all of these questions: What are we doing to take advantage of this equity market decline? How are we implementing those changes?
What, How and Why? Most of our conversations with you in the past two months have centered on one or all of these questions: What are we doing to take advantage of this equity market decline? How are we implementing those changes? Why is this a benefit to you and your family? Please be patient with a slight detour in this post, about the essential nature of well thought out and well executed procedures, especially when human emotions are stretched to the limit.
Implementation is vital to all successful outcomes. As many will remember, US Airways Flight 1549 departed New York City’s LaGuardia airport on January 15, 2009. At about 2,500 feet, the airplane encountered a flock of geese, knocking out both engines. We all know how it ended. Captain Sully Sullenberger and First Officer Jeff Skiles successfully landed the plane in the Hudson river (narrowly missing the George Washington Bridge), saving all 155 people on board. Was this luck (a little) or great process and practice (most of it)? Both Sully and Jeff had thirty plus years of flying experience. Captain Sullenberger had many hours in sailplanes (gliders with no engine). They had also practiced normal and abnormal procedures both in the airplane and the simulator tens of thousands of times before the geese ruined their day.
What’s remarkable about the 208 seconds it took from takeoff to landing in the Hudson, is how they implemented the plan. They not only completed their normal checklist items, but within two seconds of the engines rolling back, they started on the emergency checklist: turning on auxiliary power; hitting the ignition switches; communicating with Air Traffic Control and then executing a flawless landing in the Hudson. They then ensured that every passenger was out of the plane before exiting onto the wings themselves. (If you want to see the graphic of the flight path overlaid with communication both inside and outside the cockpit, click here.)
Market volatility such as we have seen recently (but we have seen it many times over our careers) is the time when process pays massive dividends. Just like Sullenberger, we know what to do when markets are moving in either direction because we have trained, practiced, and created systematic processes which take human bias and emotion out of the equation. We don’t have to guess or create a philosophy of investing since we have one already in place. During this time, we are implementing two key strategies in tandem: Rebalancing and Tax Loss Harvesting.
Rebalancing Your Accounts
All portfolios are continually monitored to compare your required allocation to your current investment allocation. In retirement accounts where there are no capital gains tax issues, we maintain your mix by trimming from bonds and adding to equities in down stock markets and trimming from stocks and adding to bonds when markets are rising. During extreme market movements, you will notice that this process of rebalancing happens more than once (for those of you who were clients during the Great Recession of 2007-2009, rebalancing continued for eighteen months).
An example: If your plan requires an allocation of 50% stocks (equities) and 50% bonds (fixed income), then in normal market times, the dividends and interest produced by the portfolio will allow us to keep this balance consistent. Our technology is set to alert us when the variance between equities and fixed income changes by more than 5%. If equity markets sell off, and your stocks are now 45% of the total and bonds 55%, we trim from the bonds and add to stocks, bringing the balance back to 50/50. Within the portfolio, we also look even deeper (like an MRI or CT scan). If your required allocation to large company stocks should be 40%, mid-sized company stocks 30%, small-sized company stocks 20%, and international/emerging market stocks 10%, when we rebalance, we will adjust these sub asset classes back to their required percentages.
Does this guarantee that you will have a successful outcome for your plan in the short run? No, it does not. But Sully and Jeff had no guarantee either. They did have the skill and procedures to face a severe situation and give themselves and their passengers the best chance at success. History shows us that markets (prices of all things we purchase and use) go up over time. By rebalancing, we can buy assets at a discount and sell at a premium. Buy low, sell high.
Tax Loss Harvesting
In your nonretirement account, we have the opportunity to take tax losses on equity positions that have taken temporary losses in value. We can sell the losing position but the IRS requires that we wait 31 days to buy it back (to avoid something called a wash sale—if you violate the rule, you don’t get to deduct the loss on your taxes). However, we don’t want to be out of an asset class in case the market moves upwards before we have a chance to buy the positions back. The rule does allow us to purchase a similar but not identical asset which is exactly what we are doing in your portfolio.
For example, a portfolio holds $200,000 worth of the iShares Core S&P Total U.S Stock Market ETF (ITOT) and has an unrecognized loss of $25,000. We can sell the position and recognize the loss. At the same time the investor can purchase $200,000 worth of iShares Core S&P 500 ETF (IVV) to maintain a similar, but not identical, exposure to that asset class. The recognized loss can now be used to offset gains in the portfolio or to reduce taxable income by up to $3,000 per year. This allows us to book a loss now, keep your allocation consistent, and have that loss to offset future gains (you can carry a loss forward forever).
Eugene Fama, who earned the Nobel Prize in Economics and is considered the father of Modern Portfolio Theory, wrote (September 25, 2014):
“Rebalancing and compounding is how retirement happens. I know people don’t like the mathematical answer to the investing problem. It’s boring. They would prefer to believe that their advisor has found some “secret sauce” that will deliver a huge return at minimal risk. The trouble is, it’s just not true.”
That’s how we manage your wealth during normal “flights” and under emergency situations. Our team is available to either go deeper into what is above or to answer any of your questions or concerns.
April 13, 2020
Glenn Ullmann founded Ullmann Wealth Partners in 2002. He is a pilot and an avid reader.