While chatting with an established financial advisor earlier in the week he brought up a line that I hear propagated within the planning community. The line is The biggest financial mistake that people make is selling at the bottom of the market. This really isn’t an accurate statement, and while some people know the difference, in the world of half baked advice and Chinese Whispers people make major financial mistakes from failing to understand what is being said.
The truth behind this myth is the line people are really saying is:
The biggest financial mistake you can ever make is not buying at the bottom of the market. Since nobody can tell exactly when the bottom of the market really is, the solution is to buy, hold and ride it out. This means that you guarantee to hit rock bottom (and come back up again). However, this is actually really bad advice, especially if you are an indexed investor.
The problems that I see arise from this are the line of thinking: It’s only a real loss when you sell it. Which is correct. The IRS will only recognize the loss when you sell it. That’s very important to understand. Most people think it means ‘if you don’t sell, you aren’t losing’ and that is incorrect. The fair market value of your investments is what it is. Sell or not sell. However, when an investment has declined in value there is a phantom event occurring in tandem with this. The amount that you have lost is actually an asset, but it can only be captured if you sell.
Example:
Billy and Joel both own a small cap ETF, they bought 1000 shares for $80 each. The market crashed, and the share price is now at $40.
Billy sells at $50 (he doesn’t know when the bottom is, but its a good enough number) he immediately buys back into a fund that tracks a different index, that protects him against a wash sale claim. Sale orders and impact:
- Buy 1000 of ABC @ $80 = -$80,000
- Sell 1000 of ABC @ $50 = $50,000 and $30,000 cap loss harvest
- Buy 500 of XYZ @ $100 = -$50,000
- Buy 1000 of ABC @ $80 = -$80,000
Want some really good advice?
You should sell at the bottom of the market, and you should buy back in again right away in an investment that is not considered ‘substantially the same’. This means that you can work around the Wash Sale rules that are in place to stop you doing this. If you want to read more on the ‘how to guide’ for that, check out the post Capitial Loss Harvesting for Passive Investors. Since you don’t know when exactly the bottom might be, you should pick an amount of loss that you think acceptable, and deploy this strategy then. Perhaps a 5% decline is sufficient.
This applies to taxable and to rollover Roth accounts
Tax loss harvesting works best in unshielded accounts, so a regular brokerage works, where a retirement account does not. However that doesn’t mean that you cannot reclaim paid taxes on ‘failed rollovers’. This means that if you do have a losing position in a rolled over Roth you can elect to recharacterize it into a Traditional IRA. This reversal of process grants a rebate on the taxes paid at the time of the conversion (from 1099-R income). So if you see a loss in such accounts, remember, it isn’t a paper loss unless you just let it be that. It is an opportunity to reduce your taxes.
If you have enough money in the accounts, Robo investments like WealthFront, Betterment and FutureAdvisor will do this for you, but if you do elect to go it alone and follow a rebalancing approach to investing, consider the advantages of harvesting losses while maintaining your stated diversification goals.
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