A To-Do List for Volatile Markets

Rough market environments like the current one remind me of the old quote from value-investing legend Shelby Cullom Davis: "You make most of your money during a bear market; you just don't know it at the time."

Easy for him to say. Yes, great value investors like Davis make their money by buying when other investors are panicking. But there's always someone on the other side of those trades. Morningstar's investor-return data, which aim to reflect investors' actual gains and losses, show that many investors mistime their purchases and sales. Before stocks began to recover in early 2009, for example, investors were flocking to bond funds, and they kept right on buying them through much of stocks' recovery. Bonds weren't a terrible investment subsequently, but they sure did underperform stocks.

Many investors have heard that they should do nothing with their portfolios during bear markets, and sitting still is certainly better than selling out of stocks altogether, or making shifts based on fear rather than good investment sense. But doing nothing may not be psychologically appealing. Moreover, there are constructive actions investors can take to improve their portfolios and their total financial plans during periods of market turbulence.

Here are four to consider.

1) Scout around for tax-loss candidates. One way to make a save during weak markets is to reap a tax loss by selling depreciated securities from your taxable account. You'll be able to use those losses to offset capital gains on your 2016 tax return, and if your losses exceed your gains, you can use them to offset up to $3,000 in income. Of course, the very securities in which you have the biggest losses may be poised to deliver the biggest gains when the market recovers, so you need to be careful that your tax-loss selling doesn't choke off your portfolio's future return potential. You can't sell something and rebuy it right away; doing so will effectively disallow the tax loss. But you can swap a losing security for another that helps you maintain similar economic exposure--for example, you could sell one losing master limited partnership and buy another, or buy an MLP ETF, instead. You may even be able to give your holdings an upgrade in the process--swapping a fund with a Morningstar Analyst Rating of Neutral for one with a Gold rating, for example, or supplanting a higher-cost index fund with one with a rock-bottom expense ratio.

Even if your taxable portfolio doesn't feature a lot of good tax-loss candidates, you can use the sell-off as an opportunity to give your taxable account a tax-efficient makeover. If one or more of your holdings has been kicking off a lot of taxable capital gains distributions and you'd like to swap into a more tax-efficient index fund or exchange-traded fund, declining market values mean that you'll owe less in capital gains taxes when you make the switch.

2) Consider IRA conversions and/or recharacterizations. Tax-loss selling from an IRA is usually not advisable for most--except perhaps investors with very small IRAs holding investments that have declined in value, as discussed here. But IRA investors can reap a benefit from a falling market, too. That's because the taxes you owe when converting a traditional IRA to Roth depends on how much of your traditional IRA hasn't been taxed yet--both your own pretax contributions as well as your investment gains. And if your traditional IRA has shrunk, as is inevitably the case when the market declines, the taxes due when you convert will be less than when markets are lofty. It won't usually make sense to convert a large IRA balance all in one go (unless you find yourself in an abnormally low tax year and have the cash on hand to pay the conversion-related tax bill--a rare confluence of events). Instead, most would-be converters would do well to convert bits of their IRAs from traditional to Roth over a period of years, to lessen the tax burden in a single year. The postretirement/pre-required-minimum-distribution years are often considered a "sweet spot" for conversions, in that most retirees at this life stage will have a greater ability to keep their income down than they will once RMDs commence.

Investors who set up traditional IRAs with an eye toward converting them into "backdoor Roth IRAs" but who haven't yet undertaken the conversion may also find it's an opportune time to convert, as their investments have likely slumped in value since they funded the accounts. That means their conversions will trigger little if any taxes (unless, that is, they have other traditional IRA assets apart from their backdoor IRA assets, as discussed here).

For investors who converted their IRAs when their balances were higher, "recharacterizing" back to a traditional IRA may be advisable. That's because the earlier conversion would trigger a higher tax bill than would be the case today, when the taxable IRA balance is likely lower. This series of FAQs from the IRS outlines the specifics of recharacterization, including deadlines and time limits.

3) Make 2015 IRA Contributions. The admonition to buy more stocks when they're down can be psychologically difficult. But investors who haven't yet contributed to an IRA for 2015 find themselves coming up on a hard deadline: April 18, 2016, your tax-filing deadline, is also your deadline for making an IRA contribution for the 2015 tax year. Procrastinators got lucky this time: The fact that stocks have fallen in the past year makes now a better time to contribute than in early 2015. The 2015 contribution limits are $5,500 for investors under 50 and $6,500 for those 50-plus; this article discusses the income limits governing deductible traditional IRA and Roth IRA contributions.

4) See if changes to your (actual) asset allocation are in order. Before you make any changes to your portfolio--either adding to your equity holdings or subtracting from them--check your asset allocation relative to your target. (If you don't have an asset-allocation target, you can look to a good target-date fund like those from Vanguard and T. Rowe Price, Morningstar's Lifetime Allocation Indexes, or my model portfolios for some asset-allocation guideposts for various life stages and risk tolerances. This article can help you further refine your stock/bond mix based on your own situation.) With U.S. stocks down about 8% in the past year and some equity categories down much more than that, many investors may find that their equity holdings need topping up. But hands-off investors getting close to retirement may find that they're actually heavy on stocks given their life stage. For them, derisking may actually be in order, even if they've been exhorted to sit tight amid the volatility. This article discusses the problem of having a portfolio that's too equity-heavy as you get close to your retirement date.