3 Ways To Gain From Market Losses

Originally in ForbesEven if you get your daily news from one of those celebrity tabloid shows, you have probably still heard that the market has been more than a little crazy in recent weeks.

Indeed, the typically overstated “surge” and “plunge” headlines have been less hyperbolic of late, as the Dow Jones Industrial Average burps out daily gains and losses in the hundreds of points. But over the past several trading days, the results have been all red, and since Sept. 18, the market has taken back more than 6% of what it’s given so far this year.

Is this volatility the precursor to another market gutting? Or perhaps it’s just a momentary ebb in advance of a continued upward flow?

The answer is yes.

The market is in the business of rising and falling, and of making fools of those who attempt to predict which it will do next. But be sure that we will feel both the pain of another big drop—perhaps sooner rather than later—and the euphoria of another unprecedented gain.

Whether this very recent pullback happens to be the beginning or the end of something, most investors have already lost enough to benefit from it.

Benefit? Yes, you did read that correctly. Here are three ways to gain from market losses:

1)   Buy low(er). Sure, this one sounds too elementary to print, right? But while few of us would disparage this most basic of investing objectives—buy low, sell high—the statistics bear out the sad fact investors too often fail to do just that. Indeed, investments have been shown to persistently outperform the investors who hold them. Investors too often sell (out of fear) when they should be buying and buy (out of greed) when they should be selling.

The most disciplined investors do just the opposite, and this discipline has a name—rebalancing. Like flossing your teeth, just about everyone’s heard about the advantages of this practice, but few implement it. Some investors rebalance periodically, but I recommend also doing it situationally. For example, if your well-conceived investment in small-cap value stocks drops by more than 15% of the proportionate allocation you’ve set, it might be time to buy more of them. Consider redistributing assets from the slices of your investment pie that have fared better into one that has struggled.

It’s emotionally confounding, I know, but entirely logical.

2)   Harvest losses in taxable accounts. Did you know that the government may pay you to lose money in the market? To be fair, you need to meet a few qualifications to receive this partial refund of your losses. And you should talk to your CPA to confirm you qualify. But capital losses in taxable investment accounts can be used to nullify capital gains. Even beyond your gains, you may be able to deduct losses of up to $3,000 per year from your income. They may also be carried forward for future years beyond the $3,000 allowance.

This point seems to conflict with the first one, though, doesn’t it? After all, the discipline of rebalancing calls for adding to positions that have lost, not reducing them. This is true, but thanks to a proliferation of index mutual funds and exchange-traded funds (ETFs), you may sell a position to gain a tax loss and buy something similar to take its place. You can’t buy the same position—or one that is “substantially identical”—within 30 days without losing your tax benefit, but there are likely a host of similar securities to choose from.

In order for this strategy to work, it’s imperative that you find that similar replacement security that allows you to stay “in the market” and weigh the cost of any trades against the value of the realized tax loss. Again, run this by your tax advisor before acting.

3)   Restructure your investment philosophy. The two opportunities described above are entirely moot unless you already have a well-conceived investment strategy at work in your portfolio. I prefer a strategy that is based on evidence—not opinion, no matter how seemingly well informed—and tailored to you based on your ability, willingness and need to take risk. Every investor, whether individual or institutional, should have an investment policy statement (IPS) that lays out a detailed strategy to which you will commit. Do you?

It is often not until market downturns that the weaknesses in a portfolio—and the soft spots in an investor’s risk tolerance—are exposed. Politicians, it seems, “never let a serious crisis go to waste,” and neither should you.

If this recent market contraction has gotten your attention, you need not stand idly by. There are opportunities to be capitalized on, taxes to be saved, lessons to be learned and decisions to be made.

Indeed, it is possible to gain something from losing.

I’m a speakerauthor and director of personal finance for the BAM Alliance. If you enjoyed this post, let me know on Twitter or Google+, and click here to receive my weekly post via email.