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Why You Should Be Happy When the Stock Market Crashes

By Sam Swenson, CFA, CPA – Oct 1, 2020 at 9:16AM

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Crashes tend to be temporary and quickly forgotten. Don't let your nerves get the best of you.

I know, I know. This is probably a tough one to sell, but hear me out: You should be excited when you see the stock market tumble. Assuming you're not a day trader -- but a true investor -- there's only opportunity to be had when the market has down days. Moments like these should trigger the desire to deploy extra cash and reaffirm your commitment to your long-term asset allocation. Remember that any reinvested cash will buy into the market at lower prices, thereby awarding you with more shares. Down days also provide opportunities to manage your tax liability.

Stocks are on sale

Stock market declines provide an opportunity for you to lower your average cost basis by investing money at lower prices. When your cost basis is lower, you'll have higher unrealized gains once the market recovers. While many of the headlines will tell you to panic sell and to be worried about humanity's very existence, the prudent move is generally to buy more of the stock market. 

Don't forget dividends

If you're investing in high-yield dividend stocks, or even just ETFs with low yields, any cash distributions from these holdings will be reinvested at lower levels when markets crash. You will then own more shares for every dollar reinvested, which will pay great dividends when the market finally recovers -- and thus, the cycle repeats. Also, by virtue of owning more shares of a particular investment, you'll receive more in dividend income in the future, regardless of where the market happens to be when dividends are actually paid. 

A bar chart with a declining red arrow, and a number of red coronavirus virions.

Image source: Getty Images.

A test of your risk tolerance

No matter how long you've been investing, emotions run wild when markets become rocky. Even the most disciplined, stoic investors can feel queasy once they see a drop like we did this past March, when stocks fell around 30%. While it's not a disaster if a drop like this made you want to sell everything, the thing that matters is whether or not you actually did.

If you had the urge to sell but didn't, you may be taking on too much risk in your portfolio, and you should strongly consider a more conservative asset allocation. If you did sell any or all of your investments, you most certainly were taking on too much risk, and you should conduct a thoughtful reallocation and rebalance before you get back into the market. Taken as a whole, a market crash provides a useful opportunity to reassess your overall risk tolerance. 

A chance to manage taxes -- in multiple ways

Stock market crashes allow you to lock in losses and apply them against gains already realized for this year. For example, say you have already sold stocks in 2020 and have long-term capital gains (LTCG) of $10,000. If the market were to crash, you could sell one of your positions with a long-term capital loss (LTCL) of $5,000 and apply it against your LTCG of $10,000. Thus, you have an opportunity to reduce your total capital gain for the year to $5,000 and ultimately pay less tax. 

Down years for the market also provide a window to convert traditional IRAs or 401(k)s to Roth IRAs. When balances in traditional IRAs are lower, you can convert this money to a Roth at potentially lower tax rates, depending on where your total income stacks up. If nothing else, you'll pay the same rate of tax but on a lower balance if you convert when markets have fallen precipitously. This represents another planning opportunity that is best undertaken in the context of a broader financial plan. 

What goes down must come up

History has shown that market crashes, no matter how ugly, resolve over time. With that in mind, try to use these breaks as opportunities to see the upside, practice restraint, and at most, make small changes to better position yourself from a tax standpoint. If you can manage to control your emotions, you'll appreciate the great benefit of having taken advantage of a stock market decline. 

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