One of the questions first time investors most often ask is, what if I lose my money right away? The key to answering this question is to keep your eye on your long term plan and not fixated on short term losses or gyrations of the market.
The reason a big drop shouldn’t bother you is because if you are investing the money you don’t need right now then you have time to recoup losses, even better it gives you a chance to reduce your average share cost if you have more to invest.
If you have been investing for some time, there is also an advantage to losses and that is to offset any gains you have in your portfolio. No matter how bad things get and no matter what the market does, I just have a tendency to be an optimist and look at the brighter side of things. When the market tends to go up over long periods of time, thinking this way over long periods of time can give you a fantastic advantage.
Active Diversifying
My investing philosophy is set up for the long term, the next 20 years at least. Having this view allows you to see the forest through the trees and have the courage to invest in sectors and industries that are not in fashion at the moment.
20 years ago the Dot-Com bubble had just burst and tech was out of fashion. Energy, Retail and Industrials (car production) through companies like Exxon, Wal-Mart, GM and Ford dominated the stock market. Emerging markets had spent the past few years being battered since the Asian Crisis and value stocks had missed the tech rally and underperformed as had small caps. 20 years ago in 2001, bonds were the best performing asset class.
Yet those same sectors which lagged through the Dot-Com boom dominated the next six years. Energy, Emerging Markets, Value and foreign shares all rallied as the dollar fell. If you had just owned an index tracking the S&P 500 in 2000, you would have underperformed a diversified portfolio that included these other sectors.
With social media and financial influencers becoming ever more important for the next generation of investors, over half of 20-39 year olds checked Tik Tok for financial advice, it can often seem like your choices are between buying crypto or tech shares and buying boring index funds. My view is that those who would like to own individual shares can do so but in the context of a diversified larger portfolio, devoting a portion, say 5% to 10% to individual stocks.
Yet the “diversified” portion deserves a closer look too and shouldn’t necessarily be limited to a target date retirement fund or simply the S&P 500. These are good starting points but just as in the past I described above, they miss key sectors that can boost performance over the long term and as we will see, they can produce tax advantages even when you have losses.
There are a number of different indexes that track different styles of investing and different market segments. When moving outside of just the total stock market index (VTI) or a target date retirement fund, it’s important to know what areas these investments are lacking in.
For the target date fund, this fund is a one size fits all yoke for the average investor. It uses an old school assumption that as you get older, especially past 40, that bonds should occupy an ever higher proportion of your portfolio. That wasn’t bad advice when interest rates were 4%-5% but at 1.5% for 10 years it’s a little harder to swallow. It also ignores risk tolerance and those that are willing to endure more risk as they get older.
For the S&P 500 or total stock market index, small caps and mid-cap stocks are underrepresented in this index. Even a small exposure of 10% of your portfolio to small cap stocks has been shown to beat an index tracking the entire stock market. This is because the large cap stocks dominate those indexes so their performance reflects this.
An example helps here. Tesla is now considered a large cap stock but at one time it was a small cap. Being an early investor is usually when you see the most gains so as the stock moved up in size and popularity, it moved from being a small cap stock to a mid-cap stock to eventually a large cap stock. Those who held those small cap and mid-cap indexes got to experience a greater piece of those early fantastic returns when few believed in the stock.
Segments of the market can under perform for long periods of time so staying the course is key to realizing the benefits of being in various markets. When you do diversify your index investing, you may also find there is another advantage to those sectors that have recently been underperforming.
The Tax Advantages in Losses
The benefit realized is through those losses in some sectors of the market which you can realize in order to offset some or all of your gains. It may help with an example.
The QQQ Trust which tracks the Nasdaq 100 is up 17.2% year to date while the Vanguard Emerging Markets ETF (VWO) is down -1.52%. Let’s assume that VWO falls 10% on the year and QQQ reaches a 20% return. Selling the VWO index and realizing the loss before year end would allow you to sell half your QQQ position (we assume for simplicity that we hold equal amounts of both indexes), and start from a new basis. The result is 0 tax paid but you now have a higher basis cost for the hot shares and a lower basis cost for the loser shares. This saves you on taxes on realized gains of QQQ later.
In addition, as markets get hot and then out of style the process can be reversed, with gains in VWO being offset by losses in QQQ.
The SEC requires that you wait 30 days to buy back the same shares and then can realize the losses for the year. This is known as tax loss harvesting and is something the wealthy have been utilizing in their portfolios for years. It just takes a little forward planning and analysis to do it yourself.
How I Apply This
I employ this strategy myself and plan to use it this year given the disappointment I have seen in some of my investments. Below are the stocks that I hold, mostly indexes and ETF’s which include some losers this year.
My overall goal is to capture the different segments and styles that will lower volatility and help me outperform over time. A portion of these are more short term like my UK shares bet and my Housing Shares bet. Others are legacy shares I have received like those of my employer or the Berkshire shares.
I attempt to capture large cap, mid cap, small cap US stocks as well as international large cap, small cap, growth and value. I am lacking in the small and mid cap growth sectors. Not listed here is a mid-cap growth fund I own through my HSA so small cap growth, which I deemed too hot lately, is the one area I need to add.
The under and over performance of certain sectors and knowing the losers will help my winners is what helps keep me invested in the long term in some of those less hot sectors. Learning to live your losers can pay in the long run.
Portfolio
VWO – Vanguard Emerging Markets ETF
QQQ – Invesco Powershares Nasdaq 100 Trust
ITB – iShares US Home Construction ETF
EXMC – iShares MSCI Emerging Market ex-China ETF
VSS – Vanguard FTSE All World ex-US Small Cap ETF
EWU – iShares MSCI United Kingdom ETF
VAW – Vanguard Materials ETF
VOE – Vanguard Mid-Cap Value ETF
VNQ – Vanguard Real Estate ETF
VBR – Vanguard Small Cap Value ETF
VTI – Vanguard Total Stock Market ETF
Shares of my Employer
BRKB – Berkshire Hathaway
VWILX – Vanguard International Growth Fund
VIMAX – Vanguard Mid-Cap Index Fund
VSMAX – Vanguard Small Cap Index Fund
VFIFX – Vanguard Target Retirement Fund 2050
NTNYX – Nuveen Flagship NY Municipal Bond ETF
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