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What to Do in a Downturn? Keep Calm and Harvest Losses

Written by: Rey SantodomingoParametric

We stand corrected: As of this writing, the S&P 500® Index is down 19% since its high-water mark on February 19, well in excess of the 10% threshold that defines a market correction and just shy of what’s considered bear-market territory. Sparked by the news of the spread of the coronavirus, the downturn that began in late February has intensified in early March as more cases of the virus are reported. 

And while there are some individual stocks—largely in the pharmaceutical and cleaning-supply industries—that have benefited from the outbreak, all economic sectors were at a loss for February. It’s been a swift and stunning plunge across the board, made all the more startling since it arrives on the heels of the longest bull market in history. Sometimes the best parties leave us with the worst hangovers.

Does that mean it’s time to get out?

We don’t think so. In fact, in our experience—and we’ve seen about five or six steep downturns since 1987, when Parametric first opened for business—this is a time to pause, take a deep breath, and keep four things in mind.

Long-term index returns are the goal

Over the long term, equity markets are expected to deliver a meaningful excess return over less risky investments such as Treasury bonds. In the short term, there will be downturns and there will be volatility. A separately managed account (SMA) can take advantage of this short-term volatility by harvesting tax losses when available and reinvesting the proceeds of these sales to support the objective of long-term equity returns. It’s worth also keeping in mind that the loss harvesting one does now in an SMA resets cost basis and sets the portfolio up for more potential tax losses in the future.

This strategy doesn’t change in this environment

Since the market peaked on February 19, volatility has increased, prices are dropping, and losses are plentiful in many investors’ portfolios. But that doesn’t mean the strategy should change. In fact, the market downturn is an opportunity to collect additional tax losses—to harvest them and reinvest the proceeds to maintain market exposure. The fundamentals still apply: Since no one can time the market, it’s important to maintain full market exposure at all times.

Don’t worry about missing out on losses

After an initial loss-harvesting trade, the market may fall further and an investor may notice additional losses in their portfolio. Or they may believe that if a loss isn’t harvested immediately, they’ll miss the opportunity. Keep in mind that on any given day the losses in a portfolio could either be reduced or continue to deepen. Capturing a loss on one day could result in forgoing a deeper loss if the market continued to fall.

Watch for wash sales

Under its wash-sale rules, the IRS disallows a tax loss if the investor purchases the same security (or equivalent) within 30 days (before or after) the sale date. As a result, it’s typically most efficient to trade accounts when there are no outstanding wash-sale restrictions—on a monthly basis at most. This is one reason SMA investors may see unharvested losses in their portfolios. It usually means the SMA manager is trying to navigate the wash-sale trade restrictions and avoid the risk of nullifying the loss-harvesting benefit. 

The bottom line

As you can imagine, loss-harvesting opportunities during this downturn have been plentiful. In the S&P 500® Index in February, over 400 names showed a loss of greater than 5%, and 72 showed losses of greater than 15%. We saw similar numbers in the international markets.

From Parametric’s perspective, the last week of February was among the busiest in our history. We harvested losses in close to 15,000 client accounts—representing over 1.35 million trades—resulting in realized tax losses of more than $240 million. Using a blended tax rate, we estimate that these tax losses could create a tax benefit of approximately $90 million for our clients.

So while market corrections like the one we’re experiencing are stressful for investors, there’s still something positive they can do for the long-term health of their SMAs. Loss harvesting allows investors to reap valuable tax benefits while still positioning their portfolios for when markets turn around again.

Related: What Policy Response Would Help to Stabilize Markets?