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The stock market has been on a downward trajectory since the start of 2022. The S&P 500 has flirted with a 20% decline, which would meet the dictionary definition of a bear market. While it can be painful to watch the value of your portfolio drop from month to month, not everyone is a loser when facing a stock market downturn.
Here are three types of investors who often find ways to win in a downturn, and two types who unfortunately are more likely to suffer losses.
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Young investors: Winners
If you’re still early in your investment career, you have a long time to come back from a stock market crash. What’s more, you likely don’t have a lot invested yet, so the impact on your portfolio, in absolute terms, is much smaller than for someone who’s consistently invested for decades.
When stock prices decline, it’s an opportunity for young investors to buy more. It’s like the market put stocks on sale. Over time, investors should expect the market to recover and go on to set new highs.
Tax-savvy investors: Winners
Investors facing significant paper losses in their portfolio after the market downturn may have an opportunity to do some tax-loss harvesting. Tax-loss harvesting is the practice of selling losing positions in order to realize a capital loss. You can then replace the sold investment with a different one that’s expected to provide similar or better returns going forward.
The reason you can’t just buy the same fund back after you sell is because of the wash sale rule. The rule says if you buy a substantially similar asset less than 30 days after selling it, it’s as if the sale never happened. As such, it would nullify the tax benefit of selling for a loss. You have to be aware of this rule because it applies across all your accounts. So, if you sell shares of an S&P 500 index fund in your regular taxable account at a loss but consistently buy shares of an S&P 500 index fund in your 401(k), it would trigger the wash sale rule.
Once you’ve realized a loss, you can use it to offset any capital gains for the year. If there are more losses than gains, you can offset up to $3,000 of personal income, which may have a higher tax rate than capital gains. Any unused loss is carried forward for future tax years.
Well-balanced investors: Winners
An investor with proper asset allocation will emerge a winner from a market downturn. There are a couple of reasons why they’re considered winners.
First of all, proper asset allocation will likely blunt their losses and keep them within their personal tolerance. A decline in stocks is often mitigated by an increase in bond prices, or at least a smaller decline.
Second, a drop in stock prices usually means an opportunity to rebalance and buy stocks when they’re cheap. Since bonds will likely become a larger part of your portfolio amid a stock market downturn, you have an opportunity to sell some bond positions and buy more stocks on the cheap. Beware: This likely has tax consequences.
2 groups of investors at risk of big losses in market downturns
1. Retirees
Retirees usually aren’t still adding money to their portfolio and may not be able to buy shares when they go on sale. In fact, they may be forced to sell shares at the most inopportune time.
Retirees can usually mitigate the impact of a stock market decline by holding a diversified portfolio. If they need to make a withdrawal during a stock market decline, they may be able to keep most of their stock positions while maintaining their target asset allocation by drawing more from bonds and other assets.
While a market downturn is certainly painful for retirees, proper investment management and a solid long-term plan will ensure they have enough to live on for years to come.
2. Fearful investors
Fearful investors can suffer huge losses in a stock market downturn. One great piece of investing advice from legendary investor Warren Buffett is to be fearful when others are greedy and greedy when others are fearful. A stock market sell-off is exactly the wrong time to be fearful.
Fear can impact investors in several ways. Some may simply hoard cash, not adding anything to their portfolio. This isn’t terrible, but you will likely miss out on returns. Waiting for the right time to invest is rarely a winning strategy.
Even worse off are those who see the market crashing and go on to sell everything they own. Those investors are then left with a big sum of cash, and they likely have no strategy for when they’ll reinvest those savings. On top of that, they may have just triggered a huge tax burden, which will drastically reduce the long-term returns of their savings.
If you can keep your wits about you in a stock market downturn, you’ll likely come out ahead, or at least be able to minimize the damage. If you let fear overtake you, you’re bound to miss out on returns.
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