How to Prepare for a Downturn
Quick, what is the first lesson you learned about what to do if you are ever lost in the woods?
If you answered “STOP,” you are 100% correct.
The exact same rule should apply to individual investors who are worried that a recession is imminent.
The second rule is “don’t panic.”
The worst investment decisions are often made under periods of emotional distress, e.g., after the loss of a job, the death of a loved one or as anxiety sets in that a recession could be near.
Why You Probably Don’t Want to Recession-Proof Your Portfolio
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 to prepare for a recession, you first must correctly predict the recession. This is much harder than it sounds.
First, there is absolutely zero shortage of pundits, journalists, talking heads and others — professionals, novices and in-laws alike — who speak confidently about the direction of the economy.
Like a stopped clock, they will be right… eventually. By that measure, a recession is always on the horizon.
But until that time, U.S. stocks could go up another 10%, 20%, 50% or more. If the recession prediction turns out to be completely wrong, it may be another five or 10 years before the next recession.
In that case, you could have missed out on more than doubling your investment in the stock market before the next recession arrives.
Keep in mind that the U.S. stock market is itself one of the strongest leading indicators of a recession.
By the time the U.S. Bureau of Economic Analysis (the government agency that “officially” declares the beginning and end of a recession in the U.S.), the stock market has probably already declined 20% or more.
But analysis shows that most people investing during a recession reallocate their investments in response to an economic downturn only after the stock market has already declined. This is frequently described as the market “pricing in” the cost of the recession or other seemingly relevant investment information.
Even worse, because investor nerves are shaky or shattered, most of them will not re-invest in the stock market until it has already recovered. In a worst-case scenario, this investor will get reinvested just in time for… you guessed it: the next recession.
4 Tips for Investing During a Recession (or if You Think a Recession Is Near)
For all the challenges facing individual investors, how can someone make intelligent and responsible investment decisions in the face of so much varied, often contradictory information? 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 sooner you can block it out and evaluate your personal situation objectively, the better. If this entails periodically checking in with a trusted adviser, 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
Also consider the likely impact on your investments and overall net worth in the event the predictions of a recession prove correct. In other words, 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 asset allocation AND the expected rate of return associated with a more conservative allocation.
Is it worth it to you to save an additional $100, $500 or $1,000 per month to avoid the more severe losses associated with investing during a recession?
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’d left well enough alone?
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 the hype and just keep doing what you’ve been doing.
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. After that, leave everything else alone.
But What if You Just Can’t Stomach a Hands-off Investing Approach?
If, after all these steps, the idea of leaving your investment accounts completely unchanged in the face of contradicting information sounds a little too Zen for your comfort level, consider the following strategies for mitigating the potential trade off between future returns and lowering overall portfolio risk:
1. Consider Dividends
Stocks that pay dividends distribute money, usually quarterly, back to shareholders. Make sure you’re investing in a diversified pool of dividend-paying stocks to as to avoid falling into a “value trap.” Sometimes high dividends can be a sign that the dividend payment is too high and unsustainable relative to the underlying fundamentals of the issuing company.
2. Look at Bonds and Other Income-Producing Investments
Suppose the stock market is projected to return 6% over the next 10 years. If you have the option of choosing a diversified portfolio of bonds or other income-producing investments, also known as fixed income, that are currently yielding 6% or more, it could make sense to opt for the diversified portfolio of fixed income.
Such options might include high-yield bonds or bonds issued by emerging market economies. These investments will also lose value in the event of a recession but may hold up better than stocks in general. You can then evaluate the option of reallocating more to stocks if and when the bad news you were expecting comes to pass.
3. Invest in Quality
Look for diversified portfolios of stocks that represent companies with strong balance sheets and consistent earnings. These companies should withstand market turbulence better than their weaker counterparts.
Again, keep in mind that the long-term rate of return may be more modest than the stock market in general — but without the opportunity costs associated with investment-grade bonds or cash.
4. Think Globally
These days, “broadly diversified” generally means including international investments. Returns between U.S. and international stocks tends to be cyclical. In the meantime, allocating some of your investments overseas can help reduce the volatility associated with a portfolio invested completely in the U.S.
A Final Word About Preparing for a Recession
The consistent theme to all of these recommendations is to consider in advance the potential outcomes associated with various 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 investment universe has to throw at you and be well on your way to a calm walk through the woods when everyone else is lost.
David Metzger is a fee-only wealth manager in Chicago. He is a certified financial planner (CFP) and a chartered financial analyst (CFA). He has taught courses on personal financial planning and investing at DePaul University in Chicago and Christian Brothers University in Memphis, Tennessee.