How to Prepare for a Downtown
Stocks have fallen into a bear market this year and the Federal Reserve is aggressively raising interest rates in an effort to cool soaring inflation.
Many experts believe an economic recession is right around the corner.
So what’s the average investor to do?
While there’s no such thing as a “recession-proof” investment, certain stocks, mutual funds and investment strategies can help your portfolio survive an economic downturn better than others.
Why Making Your Portfolio “Recession-Proof” Is Harder Than It Sounds
If you believe that a recession is imminent, you might think it makes sense to allocate more funds to investment-grade bonds, since such investments tend to hold their value better than stocks during recessions.
Alternatively, if you believe the economy will grow even faster than expected, you might try to invest more of your money in stocks. The return on stocks is typically better than bonds during periods of economic growth, which is most of the time.
Simple, right? In principle, yes.
But to correctly allocate your funds in anticipation of a recession, you first must correctly predict the recession. This is much harder than it sounds.
Keep in mind, also, that the U.S. stock market is itself one of the strongest leading indicators of a recession.
Analysis shows that most investors reallocate their investments in response to an economic downturn only after the stock market has already declined in response to those expectations. This is frequently described as the market “pricing in” the cost of the recession or other seemingly relevant investment information.
If you’re new to investing, there’s a lot to learn. Our guide to investing as a beginner breaks down everything you need to know.
4 Tips for Investing if You Think a Recession Is Near
For all the challenges facing individual investors, how can you make intelligent and responsible investment decisions before a recession hits?
Here are some tips.
1. Don’t Be Swayed by the Panic
The first step is to recognize that most of the noise surrounding you about the market is just that — noise.
The worst investment decisions are often made during times of emotional distress, e.g., after the loss of a job, the death of a loved one or as anxiety mounts over a possible recession.
The sooner you can block out emotions and evaluate your personal situation objectively, the better.
“Come up with the proper asset allocation, continue to invest into it and don’t stop,” said Thomas Kopelman, a financial planner and co-founder of AllStreet Wealth.
This can mean periodically checking in with a trusted advisor. Make sure you are working with someone who can maintain their objectivity and has a fiduciary duty to put your interests ahead of themselves or their firm.
2. Reconsider Your Risk Tolerance
Can you tolerate the fluctuations in your investment accounts associated with a garden variety recession? What about a repeat of a historical worst-case scenario?
If the answer to either question is “no,” it might make sense to re-evaluate your risk tolerance.
If you can’t stomach the thought of volatility, going with a more conservative asset allocation — even if it means a lower expected rate of return — might be a better solution.
Investing isn’t 100% risk-free but there are several low-risk investment options for people who hate the idea of losing money.
3. Consider the Costs of Missed Opportunities
Next, consider the chance that you — and everyone around you — ends up being wrong. Can you tolerate the FOMO (fear of missing out) associated with what you “could have had” if you left your portfolio untouched?
Remember, that if you are a dedicated devotee of index investing vs. active management, all publicly available information is useless for making investment decisions.
Your best bet is to ignore all of the hype and just keep doing what you’ve been doing.
“Just remember that as certain as the future seems, it has a habit of surprising us. Markets are unpredictable, full stop,” said Erik Goodge, a certified financial planner and president of uVest Advisory Group, LLC.
4. Prepare for the Worst
Work on building a good emergency fund in case of a layoff and review your insurance policies to make sure you can afford any out-of-pocket costs associated with a major illness or accident.
“It might sound counterintuitive, but one of the best steps to protecting your portfolio during a recession is to have cash on hand,” Kopelman said.
“The worst thing you can do is set yourself up to sell investments during a downturn because you don’t have enough money in your emergency fund,” he added.
But What if You Just Can’t Stomach a Hands-off Approach?
If, after all these steps, the idea of leaving your investment accounts completely unchanged sounds a little too zen for your comfort level, consider the following strategies for mitigating risk while capturing future returns.
1. Consider Dividends
Investing in a diversified pool of dividend paying stocks can help you avoid falling into a “value trap.” Sometimes big dividends can be a sign that the dividend payment is too high and unsustainable relative to the underlying fundamentals of the issuing company.
But generally, it’s a good sign when a company consistently increases its dividends to shareholders. It’s usually a signal of financial strength and healthy cash flow — traits that help companies weather a recession.
Plus a healthy dividend delivers passive income to your portfolio — something you’ll appreciate during a turbulent market.
2. Look at Bonds and Other Income-Producing Investments
Bonds play a crucial role in portfolio diversification because this asset class historically has little correlation to the stock market.
Bond mutual funds and newly issued individual bonds “become more appealing to investors as interest rates rise because you can earn more income,” said Cody Lachner, a certified financial planner and director of financial planning at BBK Wealth Management.
But whether it makes sense to buy bonds now “depends on your income needs, current level of diversification and risk tolerance,” Lachner noted.
Options might include high-yield bonds or bonds issued by emerging market economies.
The average investor can get diversified exposure to a mix of bond types through two low-cost Vanguard ETFs: Vanguard Total Bond Market Index Fund ETF Shares (BND) and the Vanguard Total Corporate Bond ETF Shares (VTC), according to Nasdaq.
Financial experts also suggest exploring Series I Savings Bonds from the U.S. Treasury Department.
These savings bonds are offering an impressive 9.62% return now through October with very low risk.
The high rate won’t last forever, but I bonds do serve as a hedge against inflation — something few other investments can promise.
There are a couple big caveats though: You must hold I bonds for at least a year before you can cash them in and there’s a $10,000 purchasing cap per year.
3. Invest in Quality
Look for stocks and exchange traded funds (ETFs) that represent companies with strong balance sheets, stable margins and consistent earnings.
These companies should withstand market turbulence better than their weaker counterparts.
Look for strong performers in sectors like utilities, health care and consumer food staples, which tend to perform better during economic downturns than some other industries like airlines, travel and car manufacturers.
Utilities and health care stocks may not be very sexy or appealing during bull markets because growth tends to be modest.
But during bear markets and recessions, purchasing shares of companies that supply consumers with everyday essentials is a smart way to diversify your portfolio.
4. Think Globally
These days, “broadly diversified” generally means including international investments.
Returns between U.S. and international stocks tend to be cyclical. Allocating some of your investments overseas can help reduce the volatility associated with a portfolio invested solely in U.S. companies.
5. Look at Mutual Funds and ETFs
Handpicking individual stocks is tricky and time consuming.
The average investor is better off exploring mutual funds and ETFs that either track a broad market index (like the S&P 500) or a specific industry sector (like health care).
Investing in funds gives you exposure to dozens of different companies with a single purchase — instant diversification.
Taking this approach during a recession is a smart way to invest in several companies in well-performing sectors without concentrating your risk in any single company.
The take home message here is to consider in advance the potential outcomes associated with different scenarios: both in your personal life and across the economy in general.
By doing so, you will be much better prepared to withstand most (if not all) of what the stock market has to throw at you.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder.
David Metzger is a fee-only wealth manager in Chicago. He is a certified financial planner (CFP) and a chartered financial analyst (CFA).