Vector Wealth Management

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Strong Market Performance & Rebalancing Opportunities

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In our latest podcast episode with Jason Ranallo, we dive into strong market performance over the last couple of years and rebalancing opportunities. Listen in to learn how prior year tax carryforwards work and how investors use them to offset taxes on future capital gains.

Jason explains how investors can use tactics like rebalancing and tax-loss harvesting in their portfolios. Plus, we discuss importance of staying proactive during both up and down markets.

Key discussion topics:

  • Understand how tactics like rebalancing during strong market years and tax-loss harvesting in down market years can affect your portfolio.

  • Throughout different market cycles—ups and downs—there are levers to pull.

  • When you’ve used up your tax-loss carryforward buffer. What next?


Chapters

  1. Market Performance Overview (Last 11 Years)
    00:00:03 - 00:00:45
    Overview of the stock market’s positive performance over the past decade, with 9 of 11 years being up.

  2. Annualized Market Returns and Diversified Portfolios
    00:00:53 - 00:01:26
    Discussion of annualized returns for the stock market and diversified portfolios.

  3. 2022: A Challenging Year for Investors
    00:01:46 - 00:02:30
    2022 was one of the worst years for both stock and bond investors.

  4. Tax-Loss Harvesting and Carryforwards
    00:03:10 - 00:03:48
    Introduction to tax-loss harvesting and how losses from down years can reduce future taxes.

  5. Rebalancing in Strong Market Years (2023 and 2024)
    00:04:09 - 00:05:10
    Importance of rebalancing during strong market years to maintain portfolio balance.

  6. Leveraging Tax-Loss Carryforwards in Up Market Years
    00:05:10 - 00:06:07
    Using carryforwards from past down years to offset gains in strong market years.

  7. Human Emotions and Market Volatility
    00:07:23 - 00:08:14
    Discussion on how human emotions influence investment decisions in both up and down markets.

  8. Investment Strategies for Retirees vs. Accumulators
    00:09:10 - 00:10:08
    Comparing strategies for retirees (withdrawing funds) versus accumulators (adding to portfolios).

  9. Tax Implications and Timing of Rebalancing
    00:10:08 - 13:57
    Addressing how taxes affect rebalancing decisions and the importance of balancing tax impact with portfolio growth.


Full Transcript

(Transcribed using AI - Variation possible)

If we look back over the last ten, eleven years, the stock market, the financial markets have been for the most part in a pretty strong upward movement. In fact, just before this, we found that nine of the last eleven years, counting this year, the markets have been positive. So there's two negative years in the last eleven. That's a pretty good run. And some of those positive years were really quite positive. Strong years. You're talking about just to set the frame here, so it’s generally the S&P, the big companies in the US that we're saying, that that market, that pool of companies has been up nine of the last eleven years.

You did some math here too, which says kind of annualized, like per year on an average, on a ten-year basis, if you go ten years back or something. So over the last ten years, the stock market's up over 13% on an annualized ten-year basis, 13 and 13.3. That's just the stock market, which, of course, diversified investors are going to own other things like bonds and perhaps some international companies, some smaller US companies. Even a balanced portfolio, a balanced index is up, you know, 8.6% annualized over the last ten years. Again, many strong years in there. And that includes owning bonds, like I said, and other asset classes outside of the US large segment.

I think what's interesting here is that life's been good if you've been an investor. Maybe that's the big takeaway and that there's been some down years, and I think that's partly what we want to talk about. Our last down year was in 2022. Yeah, that was the big one and the most recent big one. 2022 goes down as being one of the worst years for not just a stock investor, but a diversified portfolio investor, because that was the year we had bonds. The bond market was down about 13%, and the stock market was down about 18%. So from a balanced portfolio perspective, it was a pretty big down year.

Zooming in just in the last few years, we see that 2022 was a big down year. Generally, 2023, we saw some pretty good recovery. And then of course, this year, 2023, the market was positive, up pretty sharp, both balanced portfolios as well as the stock market specifically. And then this year's not a great example, where the stock market this year has been performing quite strong as well. And we're just at the top three quarters of the way through. So, when we have those down years, there are things that we do, and when we have up years, there are things that we do as investment managers and people looking after portfolios.

Let’s talk through that. Let’s start with the down year first. When we go through down year periods, oftentimes, one effective tool we use is tax loss swapping. If there are investments that are held that have unrealized capital loss, we can sell that immediately, transfer that or sell it and buy a similar type of investment, realize that capital loss for tax purposes, which helps lower future tax bills while maintaining a similar market exposure. It’s a way to, in a down market, create some tax efficiency going forward. And I think we talked earlier that those losses can carry forward, right? The losses realized in 2022 aren’t just for 2022 necessarily. A capital loss carryforward can be carried forward indefinitely. Until you use it up, I suppose.

That brings us to those up market years, right? I mentioned 2022 was a down year, 2023 was an up year, 2024 has been an up year so far. We get into up years, and in these recovery periods, oftentimes there are other actions we're taking, whether it’s rebalancing. Assets are moving in different directions at different times, and they might get out of tolerance from what we expect. They might be ahead of expectations, for example, at which point we look to rebalance, trim them, and buy other types of investments in the portfolio. So, if the market has done well in 2023 or 2024, you might sell some of that within a portfolio. Because you took losses, even though maybe you bought something similar or maybe rebalanced again—it’s individualized stuff here—but in 2022, you’ve carried that forward, and the gains you’ve made are offset in some part by those losses you realized.

Just to put some numbers behind it: say, for example, a $50,000 loss was realized in 2022, and in 2023 or 2024, you still had that $50,000 loss carryforward. You could offset approximately $50,000 of gains in that following year and basically have a wash or net out. Maybe it’s $25K one year and $25K the next year, and you’re kind of using up that buffer. When you file your tax return, individual investors are able to take $3,000 a year of loss carryforward at a time and offset that against ordinary income. But for the most part, we’re just talking about capital gains and losses. So, at some point, what we see is that individuals will start to use up their tax loss carryforward, especially when you get through stronger market years like we’ve had for the last couple of years.

If we’re looking back eleven years, and nine of them have been largely positive in the market, you’re going to have more positive years than down years. So it’s almost like you want to take advantage of those down years when they come. But this is where that tax intersection comes in. In those up years, which are more frequent, looking historically, there’s a tax bill. There can be, and depending on individual circumstances, that may start to occur around this time. We've had a couple of really strong years. In terms of a retired couple that we're rebalancing, we’re setting aside dollars for their income needs. As the markets have moved higher, their portfolio has been performing well. Now it could be a scenario where they’ve used up all the tax loss carryforward, and maybe now there’s a tax bill from capital gains realized from rebalancing activity or repositioning to other different investments.

But the takeaway here is that throughout these different market cycles—ups and downs—there are levers to pull. And in up markets, especially, we want to make sure that we’re prudently rebalancing when we can, looking for different opportunities when they present themselves, and ensuring that the tax tail doesn’t necessarily wag the dog. We talk about the human emotions. It’s not just numbers on a spreadsheet or your portfolio. Human emotions are involved. When we see the number going up in that portfolio balance, that number being higher, we feel pretty good, right? And we think it’s going to be like this forever.

The tendency is human nature. To think that where we are today is where we’ll always be. That happens when markets are going down, too. It can be really fatiguing to watch markets drop, and you’re wondering when it will turn around, how long it will last. The same is true on the flip side: these moments in time, these quarters and years of really strong performance, but still, as we have to say, it’s important to take a prudent approach and make sure we’re measuring and adjusting for what we’re asking the portfolio to do and what investors are asking the portfolio to do. It’s a bit of what is the market doing, and what does that policy require? What do we need that money to do? Maybe it’s individualized kind of tranches or segments, like setting aside for years one, two, and three in the case of a retired couple.

We find, too, that spending patterns can and do change over time. Those spending needs from portfolios can change and may not always align exactly with how the markets are performing. The years where you plan to spend more may not always be an up strong market year. We want to make sure that we defend against that, setting aside the dollars, taking away that risk from short-term volatility, so that we have the dollars available. I feel like this conversation is largely around those who are post-retirement or living off of their portfolios, maybe Social Security and other investments. This makes sense for that scenario. Is there another scenario where you’re still in the accumulation phase? Does that change anything? Are the cues to take action different?

Yes, because you think in terms of portfolio and whether you’re putting money in or taking money out, right? For those retirees, they’re generally taking money out. The flip side, though, is for accumulators, who are generally adding—whether it’s a 401(k) through their employer, or just saving into a brokerage account. In those scenarios, by adding regularly, that’s effectively a rebalancing mechanism. So, it’s not uncommon, or one possible path, is that rebalancing occurs over time as new money is put in. Part of that is automatic rebalancing. So in those scenarios, accumulators may have a different tax experience because their rebalancing is different. Maybe it’s still tax loss harvesting opportunities, but in terms of rebalancing with new money coming in, that’s another lever to pull for an accumulator versus someone in the distribution phase.

Taxes should weigh on decisions regarding when it’s appropriate to rebalance, and how much to rebalance, but it all comes back to individual circumstances: what their risk tolerance is, and what they’re asking their assets to do. Different investments in a portfolio have different jobs and levels of expectations. If we see investments ahead of or behind expectations, that might trigger a good time to rebalance. We always want to keep taxes in mind, because it comes down to what you keep, not just what you make. Over time, we balance the tax implication with market growth and investment opportunities.

You mentioned a diversified portfolio might return 8.6%, while a straight stock market portfolio might return around 13%. So, if returns are above expectations, it’s prudent to sell some. And we have been above expectations. The stock market doing over 13% for the last ten years is above expectations, as the stock market tends to do about 10%. In that environment, we can and should expect more potential rebalancing, more changes in the portfolio, as it gets more out of tolerance from the plan and investment policy we built together. Some people may wonder: how often should I rebalance? Is it just market-driven? Is it driven by goals or externalities?

A lot of times for us, it’s heavily market-driven but also influenced by goals. As people change their spending over time—taking on more or less—that dictates how much they should have set aside for short-term living needs. The rebalance tolerance or threshold may change, but it’s largely based on financial markets. We’ve been through two strong years of market up movements, and looking back at 2022, many investors may have used up their tax loss carryforwards. The takeaway now is that portfolio management activities remain prudent, especially as markets fluctuate. If markets go up strong, that’s great, but it can also mean more realized capital gains. Of course, it depends on individual circumstances. While nobody wants to pay more taxes, it’s necessary in terms of buying low, selling high, and planning for the long term.


These discussions aim to spark dialogue about enhancing retirement readiness and making more informed financial decisions. At Vector, we delve into the nuances of scenario planning, offer insights and guidance tailored to each client's unique circumstances. If you or someone you know is pondering their financial future or seeking clarity on their retirement plan, we're here to help.

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Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and unless otherwise stated, are not guaranteed. 

Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for any individual. Listeners are encouraged to seek advice from a qualified tax, legal, or investment adviser to determine whether any information presented may be suitable for their specific situation.  Past performance is not indicative of future performance.

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