This summer was the first time in a few years ravaged by COVID that we could finally go out and play as a family again. It also was a time for a down market to hit. Higher gas prices and inflation nipping at our heels wasn’t fun to witness while traveling.
A down market feels risky and unknown. Leading to further questions about: How can I prepare during this time? Where should I be putting my money? Should I be selling my vested company stock / RSUs?
How can I prepare during the down market?
Now is the time to reassess your family burn rate. Those tried and true words of ‘always have an emergency fund’ rear their head again! Are you living within your salaries? Do you require additional funding from your RSUs or stock options? How can you give yourself the most leverage to ‘wait out’ this season of a down market.
Consider tracking your expenses through a budgeting tool like YNAB or mint.com. Even if you don’t follow a budget to the law, this will let you see a good trend line. If you’d like something more manual, you can use this handy spreadsheet to catch some of those non-monthly items that stack up.
Knowing your burn rate gives you the freedom to realize other opportunities.
If your burn shows you have a risk in not having enough cash, this also gives you time to build up your cash reserves. The rule of thumb is if you are a single breadwinner, 6 months of reserves is best. If you are a dual income family, then 3 months may be adequate.
Tax-loss harvesting. The ability to take advantage of tax losses on your tax return is a pretty significant opportunity, especially for folks with large portfolios or equity comp. Tax loss harvesting works by selling assets at a capital loss and using that loss to offset other capital gains. This type of strategy can only be employed during down markets or high volatility in an asset class. During years such as 2022, you may be able to harvest a good amount of losses to help smooth and optimize your tax bill.
This gets into a very technical zone to do yourself. The loss must have substance to be utilized. I love this super nerdy and well outlined discussion from Kitces on who benefits best in this situation (with visuals) and the pitfalls if you are attempting this yourself.
Converting IRA funds to Roth IRA accounts. Depending on your taxable income for the year, there may be an opportunity here. The primary advantage of Roth assets is their current tax-free nature in growth and qualified distributions. This conversion will generate taxable income now, on hopefully ‘lower priced’ assets than if you did the conversion in the future. In essence, you choose to pay a tax bill now rather than in the future. One of the variables you should be mindful of is the Federal & State marginal tax bracket and your effective tax rates. Please consult with your tax advisor before engaging in this strategy.
Where should I put my money in a down market?
Once you know your burn rate and cash on hand, any remaining cash can go towards future growth.
If you have a big purchase to make in a few years, you may wish to take less risk in your investments and go for a well diversified stocks and bonds portfolio.
If you have cash on hand that you believe you won’t need for many years, this may be a time to look at exercising lower valued stock options.
Exercising incentive stock options (ISOs) in a down market
One of our favorite opportunities to explore during down markets is the exercise of Incentive stock options (ISOs). This strategy is a concentrated risk that requires a strong understanding of how much cash you are willing to lose. Once you know how much cash you are willing to ‘lose’ towards such a risk, you can consider the options below.
- Private companies: If your company is private and they take a “down round”, employees with Incentive stock options (ISOs) may have an opportunity to get a bigger bang for their buck. ISOs may be subject to AMT tax at exercise on the value between the share value price and the exercise price. During a down round, the employee may be able to exercise more options before hitting the AMT tax threshold. Please be mindful that sometimes there are exercise lock out periods and other restrictions.
- Public Companies: Very similar to private companies; however, their valuation fluctuates minute by minute on the public exchanges. During these decreases in stock price, stock option holders may want to exercise shares when they feel the price will be “low & optimal”. Again, this is always a risk since you are going off of a feeling in one particular stock. If you are sure you can take the risk, this may be an opportunity for you. Generally, public company tech employees can exercise their options outside of a trade window. If you see your stock price is falling a decent amount, you may want to consider exercising options.
What if you already exercised early this year? Keep in mind that the AMT is an annual aggregate calculation. All ISO exercise value goes into the AMT calculation. One strategy is to sell previously exercised shares from the current year (which makes this a disqualified disposition treated as ordinary income and remove them from the AMT calculation). This may allow you to exercise a greater amount of ISOs at the same level of cash outlay if you are above the AMT tax thresholds. We recommend working with your tax advisor to complete this strategy.
Should I exercise non-qualified stock options (NQSOs) in a down market?
The philosophy behind this exercise is similar to the ISOs, but with the added complexity of taxes due at exercise. Remember, NQSOs will generate income once they are exercised and will be subject to required withholding taxes. Then, at your tax return time, you may owe additional taxes if your effective tax rate is higher than the taxes withheld at exercise.
It may make sense to exercise a small amount of NQSOs if you do not have ISOs, but be ready for the taxes due at exercise. If you have ISOs, you may be able to achieve more shares held through focusing on exercising ISOs instead.
Should I be selling my vested company stock / RSUs?
If the vest just happened, then yes, you should deeply consider it. This should be part of your strategy to diversify out of your company shares and into a well maintained portfolio that can do more work for you longer term.
For older shares, I would ask you at what price you are willing to part with it? If the stock was that price after vest, then why didn’t you sell it then? We often feel we know our company much better as an ‘insider’ and that the stock price will definitely reach $X or in three years will get to $Y. The number of times I’ve heard this, and it never got to that point, is very high. We don’t always know what the stock market will do in a shorter term because large players are pricing in their expectations as well. Leading to short term noise and erratic behavior. This down market has certainly shown that volatility time and time again 🙂
We believe in dollar cost-averaging out of company stock over time by selling RSUs at vesting. So at the least, consider selling pieces over time so you are not left wishing you had taken some off the table and less risk with your nest egg.
The above discussion is for informational purposes only. Recommendations are of a general nature, not based on knowledge of any individual’s specific needs or circumstances, and there is no intent to provide individual investment advisory, supervisory or management services.
