The stock market is down 19% year-to-date, so what is an investor to do? There are plenty who
are exhausted by the continuous grind toward lower prices, even with some trend-reversal
rallies mixed in. They want to sell because they’re worried about stock prices falling even
further than the mid-October lows. No one has a crystal ball that reveals when the market will
turn and a new bull market will start. With history as a guide, a new bull market would start
while the news narrative still feels awful. Stocks would bottom, GDP growth would bottom a
bit later and eventually earnings would bottom. Stocks tend to be off to the races once they
begin climbing, even as economic growth and earnings still look poor. That seeming
boomerang effect should discourage selling…if an investor is selling to stay on the sidelines.
Selling with the market down sharply may, however, be a savvy move if it’s done for the right
reason and the investor stays invested in the portion of the portfolio allocated for stocks. If an
investment account is subject to capital gains taxes, selling at a loss means the owner can use
that loss to offset gains taken in the same year or future years, and thus avoid all or a portion of
the tax on capital gains. This tax loss harvesting is useful when an investor wants to pare down
a holding that has performed extraordinarily well relative to the rest of the portfolio and gotten
a little too big relative to the intended allocation. Those losses are also useful when an investor
would otherwise have to pay capital gains taxes to reallocate among stock sectors or switch
into new holdings with more attractive valuations. Those losses are definitely useful after the
stock market has had a bull run and investors want to harvest gains to invest in a less volatile
asset like bonds. Bond returns have been uncharacteristically volatile during 2022, but
investors holding bonds until maturity need not be as concerned about the price of those bonds
between now and the maturity date.
How should an investor decide which losses to harvest? It’s a fairly easy decision when there’s
a very similar company to the one being considered for sale. Another factor to consider is
whether there are potential near-term positive catalysts for a stock pricing at a loss. To be able
to use a loss for tax purposes, an investor must wait 31 days before repurchasing the same
security or investing in a “substantially similar” security. If there’s a near-term catalyst, the
investor might risk foregoing a potential upside recovery, but that same catalyst might
positively impact other stocks in the same sector. There’s no definitive answer whether to
harvest a particular loss, but harvesting losses and reinvesting the proceeds can both produce
tax advantages and maintain the desired market exposure.
Selling at the lows may sound contrary to textbook investing advice, but harvesting losses and
reinvesting the proceeds is very much in line with two concepts in that same textbook – tax
efficiency and staying invested. Investors are well-served to remember that it’s time in the
market rather than timing the market that is most likely to build wealth over time, but if you
can make bear market losses work to your eventual advantage, then it’s all the better.
