Bear markets are only part of investing. Here's how to get the most out of it
Falling stock prices in a bear market can leave a sour taste in the mouths of retirees who rely on their investments to fund their lifestyles. But instead of bailing out of the stock market at the wrong time or wallowing in your financial misfortune, a better strategy is to turn a lemon market into lemonade. “There are some things investors can do to take advantage of potential opportunities in a bear market,” says Brian Walsh, senior director of financial planning at online financial firm SoFi.
What you don't want to do is panic and hurt your long-term finances by making fear- and emotion-driven portfolio moves that will push you deeper into a hole says Jerry Braakman, president and director of investments at First American Trust. What is past is past. Your job is to minimize the damage caused by the market downturn and plan for the future. "You want to position your portfolio for the next phase of the market," says Braakman.
Remember that bear markets eventually come to an end. History tells us that stocks eventually recover.
So what should an investor do?
1. Buy stocks on sale
A bear market drives stock prices down from expensive to cheap. At the bear market low in mid-June 2022, for example, the S&P 500 was down nearly 24% year-to-date. And that Wall Street discount equates to a big sale, no different from the massive markdowns during the Black Friday holiday sales.
So avoid selling stocks at depressed prices and locking in losses. Instead, consider buying stocks of quality beat companies that sell popular products. You'll profit from lower prices and the eventual rebound, says Falko Hoernicke, senior portfolio manager at U.S. Bank Private Wealth Management. "You'll likely find some hidden gems," Hoernicke says.
But don't buy junk inventory on sale. Instead, buy stocks of companies that are number one or number two in terms of market share in their industry and have the pricing power to continue generating healthy profits, adds Hoernicke.
2. Consider a Roth IRA Conversion
With stock prices falling, now could also be a good time to convert from a traditional IRA or an employer-sponsored qualified retirement account. These accounts were funded with pre-tax dollars and require you to pay taxes on withdrawals. The advantage of the Roth is that you will pay no tax on withdrawals for life, provided you do not use the account for five years. You'll also avoid having to pay required minimum distributions (RMDs) while you're alive (regular IRAs require you to take RMDs starting at age 72). Another advantage is that you will be able to pass on tax-free assets to heirs.
The problem? You'll have to pay taxes at your ordinary income rate on the dollar amount you convert to a Roth IRA.
Doing a conversion in a bear market can make sense, mainly because the dollar value of the IRA is now lower due to the stock market downturn, which means you'll pay less tax on the conversion than you would when stock prices were higher at the peak of the market.
Say, for example, you want to convert your entire IRA balance—now valued at $100,000, down from a pre-bear value of $125,000—into a Roth. You will benefit from this in two ways. First, your tax impact will be lower because your account will be $25,000 lower. Second, you'll move the same number of shares despite the IRA losing value, which means you'll be better able to take advantage of the market rebound. “When the recovery comes, all your shares will be in a tax-free account,” says Tim Steffen, director of tax planning at Baird, a fund management company. And the more stocks you convert now into a tax-free Roth IRA, the more potential earnings you can earn in future years when those stocks appreciate in price under the Roth umbrella.
A Roth conversion works best, according to Wells Fargo, if you won't need the money for at least five years, because IRS rules prohibit tax-free withdrawals until at least five years later. your first contribution to the account. A Roth makes more sense if you expect to be in the same tax bracket or in a higher tax bracket during retirement. It's also best if you have the cash to pay the tax bill without using IRA funds because you want as many stocks in the IRA as possible to benefit from future growth.
Wells Fargo says a Roth IRA conversion makes less sense if the converted dollar amount pushes you into a higher tax bracket in the tax year you're converting, or if you think you are in a much lower tax bracket when you retire. The tax advantages of a Roth IRA are also less impressive if you live in or plan to move to a state with no income tax or lower income tax.
3. Sell losing stocks to lower your tax bill
Of course, it's a drag when your stock investments lose value and are now worth less on paper than when you bought your stocks. But the thing is, portfolio losses do have some value, and they're especially helpful when it comes to lowering your tax bill.
Bear markets are a good time to reap tax losses, says SoFi's Walsh. Simply put, it's when "you turn losses on paper into real losses in order to save money on taxes," says Walsh.
When you sell your Lemon shares, you can use the losses to offset your winners' taxable capital gains. And once you've used the losses to offset all of your capital gains, you can also use the losses to offset up to $3,000 of ordinary income on your tax return. And if you still have losses, you can carry those losses forward to future tax years.
Let's say you have a $20,000 gain on energy stocks in 2022, but you have $25,000 losses on hard-hit tech stocks. If you sell your winning energy stocks, you can use the $25,000 loss to offset your $20,000 gain. You can offset $3,000 of ordinary income. And you can carry the remaining $2,000 of losses forward to future tax years to offset the gains.
4. Rebalance your portfolio
Now is not the time to haphazard your portfolio. It's time to be disciplined. And that means making sure the mix of stocks and bonds in your portfolio doesn't get too out of whack due to market fluctuations. Even if your financial plan calls for 60% equities, the bear market may have reduced your stock holdings to only 50% of your portfolio.
Now is the time to sell other assets in your portfolio that now make up a larger portion of your holdings and buy downed stocks to bring your stock allocation down to 60%. "Portfolio rebalancing," says SoFi's Walsh, "can drive long-term improvements" in your returns. “You are selling winning investments and buying losers. So you buy more shares of investments that are low in price and that can help your money grow over a long period of time.