Market crash to-dos:
Reinvest at a discount
Tax-loss harvesting

One of the harder questions I’ve had to answer is “what is a financial plan?” The reason this is hard to answer is because a plan is like the shape of water. The way water takes the shape of its container, a financial plan will take the shape of the household for whom it is designed. No two are alike.

Broadly speaking there are three kinds of financial plans:

1) The Wizard Plan. I don’t actually call it that. But I probably should.

The Wizard Plan involves putting on a Gandalf hat (not really) and using fancy software (really) to analyze a person’s income, assets, liabilities, potential future returns, and the likelihood that the person will run out of money during their lifetime. The process creates a best-guess idea of whether a person is on track to meet a far-off goal.

The reason this is the Wizard Plan is that it is a fantasy. There is almost no utility in forecasting something more than a handful of years from now. There is simply no way to account for unknowable future events accurately. There is no mathematical benefit in solving an equation with too many variables, and there is no emotional benefit to the people involved. Our monkey brains are worried about right now and can’t fathom 30 years from now.

Rightly or wrongly, this is the kind of financial plan that most people think of when they think of financial planning. As unrealistic as it is, the process of creating a Wizard Plan has the benefit of revealing present-day problems. Fixing these problems leads us to…

2) The Fix It Plan.

Sometimes, in the process of creating the Wizard Plan, a problem shows up. Examples include:

• Someone has legacy goals but hasn’t updated beneficiary designations or has no Revocable Living Trust to avoid probate. Fix It Plan time!

• Someone has no tax efficiency built into their retirement income. Fix It Plan!

• Someone has young children but has no life insurance and isn’t saving for college. Fix. It. Plan!

The Fix It Plan provides a few clear steps to correct an immediate problem. Personally, this is the most rewarding kind of plan. It addresses something that isn’t working, and results can be felt in the short term.

Once these short term issues are cleared up, we can proceed onto…

3) The Foundation Plan.

This is my favorite type of plan. Think of the Foundation Plan as the foundation of your house. It gives you firm footing to build whatever you want on top of it. A Foundation Plan looks at the income, assets, and liabilities that we discover when creating the Wizard Plan. If there is no Fix It Plan needed, then we can put a good foundation in place.

What is a good foundation? A good foundation is a plan that accounts for the unknown quantity and severity of storms that may occasionally batter your financial house and puts systems in place to minimize the damage. Our fancy software can’t predict that a metaphorical tornado will tear your proverbial roof off 20 years from now. But we can build a metaphorical storm shelter when the symbolic weather is clear.

Regardless of political administrations, geopolitical events, environmental crises, inflation, etc., you can rely on the fact that once to twice per decade there will be a significant market correction. The fancy term for this is “systematic risk.” The defining characteristic about systematic risk is that there’s no way to diversify against it. You’re going to ride the wave, like it or not.

Quarter 2 of 2022 has not been a fun ride so far. While there are some signs suggesting the ride may be about to turn around, there’s no way to be sure.

What would a Foundation Plan do in this situation?

For starters, a Foundation Plan would ensure that a person’s income – whether from earnings or investments – will let them avoid having to sell investments to fund expenses. Selling investments during a market correction is one of the cardinal sins of investing best practices. Some mechanism should be in place to prevent a person from needing to do this.

Secondly, a Foundation Plan would look at a person’s portfolio and find opportunities to turn a market correction into a net positive for the investor.

One benefit of a market correction is that it creates opportunities for tax harvesting in a taxable investment account. What is tax-loss harvesting?

Tax harvesting is selling a stock or fund at a loss, which creates a tax deduction of up to $3000 per year. Any loss in excess of $3000 is carried forward to future years. By banking losses in this way, a person can get out of a losing position in their portfolio while creating a loss that offsets the impact of present or future trades where the investor recognizes a gain. Tax loss harvesting adds value to a portfolio by turning a losing position into a present, and potentially future, tax benefit. I recently did this in my own taxable investment account when freeing up cash to invest in Series I Bonds.

A second benefit to a market correction is that, for long-term investors, it creates opportunities to buy into the market during one of the rare times when prices are low.

Look at the history of annual returns of the S&P 500. Since 1950, there have been 18 negative-performing years. That’s it. 58 positive years, 18 bad years. That’s a “bad year” rate of about 25%. You will rarely get an opportunity to buy into the market at “discount” prices. When those opportunities appear, a Foundation Plan will have built conservative positions during those positive years. These positions won’t crash with the market. Even better, these funds can be rebalanced into the market, if the investor chooses to do so, to take advantage of the rare low price opportunity.

One way an investor can automate this “buy low” process is to have a dividend reinvestment program in place. Dividend reinvestment simply takes the income generated by dividend-paying stocks and funds and buys more of the stock or fund that produced them.

While market corrections are some shade of painful for everyone, the extent to which that emotional pain translates into financial pain can be modulated by good financial planning.

Do you have a plan in place for the 25% of years where the market gets sea sick? If not, or if you want a second opinion on the plan you do have, we’re here to help.