Recessions are scary and unnerving for everyone, however, they are part of the business cycle and part of life. The Covid 19 pandemic caused the latest but shortest recession in history. Very few global economies have returned to normal yet, and most have not recovered from their initial downturns.
Economic downturns are scary times for everyone, especially for investors, as they might see a big drop in their investment portfolios. Fear and sometimes panic take hold when economic trouble goes hand in hand with economic indicators such as a spike in unemployment and a decline of the quarterly GDP.
Many investors are asking themselves and their financial advisors how to reduce their losses, how to make adjustments to their asset allocation in their portfolios, and even whether to cash out completely. Cashing out or liquidating your holdings at such times can be devastating to your financial health. Also, swearing off new investments during economic downturns and recessions can have huge opportunity costs.
Although investing during a recession is often unnerving, recessions can also create some of the stock market’s best opportunities. Smart investing during a recession can result in smaller losses, leaving more capital to reinvest at lower and often undervalued prices for high-quality stocks. It is in such situations that lasting wealth is often created. Just look back at the 2008 recession. Many investors thought it was the end of the investing world. However, it ended up being the buying opportunity of a lifetime for many, ahead of a 10-year bull market.
Navigating a recession while staying in control of your personal finances and remaining on track to meet your financial goals is more about a mindset than a technique. This article explores time-tested investment strategies and tips for some of the best recession-proof investments that have helped many investors preserve and grow their wealth during even the worst economic times.
What Is a Recession?
A recession is when a nation’s economy experiences an economic decline of at least 6 months and a decrease in its Gross Domestic Product (GDP) for 2 consecutive quarters. Such negative economic growth results from a slowdown in the economy accompanied by declining stock prices, increasing unemployment, declining manufacturing numbers, and low consumer confidence.
Many factors can cause a recession; a financial crisis, rising interest rates, falling asset prices, falling consumer/business confidence, trade wars, fiscal policy, and unexpected events such as pandemics.
The global Covid pandemic has brought economic activity nearly to a halt in many countries. It seems that many economies are heading towards recession with declining GDPs for the fiscal year 2020. According to the U.S. Bureau of Economic Analysis, real GDP in the U.S. decreased in the first quarter of 2020 by 5.0%, and in the second quarter, real GDP decreased by 31.4 percent. In the 3rd quarter, the “advanced” GDP estimate increased at an annual rate of 33.1 percent. This shows improvement, but a recession is still looming.
Investing Principles to Adhere to During a Recession
With global asset prices declining during a recession, this can be a great opportunity for investors to take advantage of lower valuations in assets such as stocks, commodities, or real estate that are sure to rebound once the economy is back on track.
If you plan on investing during a recession, there are certain essential principles that you need to adhere to, along with certain prerequisites to implement a smart investing plan effectively.
Have Sufficient Cash Savings for Emergencies
Having sufficient cash on hand in a savings account or a money market account is crucial to a good investment plan during a recession. Times are unsure, and the Covid pandemic shutdown has resulted in job losses, pay cuts, and increased expenses for many people. It is essential to have enough cash on hand to deal with these types of emergencies, so you do not need to sell some of your long-term investments at a loss or very low price to pay for these emergencies. Experts suggest keeping at least 3-6 months’ worth of expenses in your emergency fund.
Not only does cash provide flexibility, but it also comes with peace of mind. During a down market, cash is pretty much risk-free and offers a great short-term solution to stay defensive during a recession. Remember, this should not turn into a long-term strategy. When the economy starts to recover, you will have the cash available to invest in some low-priced or undervalued stocks that produce higher returns.
Keep a Long-Term Focus
Investing during a recession is not for those who are looking at short-term goals. Timing the market is usually not a good strategy, especially during a recession because of increased market volatility. It is impossible to predict with certainty when to enter and when to exit the stock market. Most investors usually wait too long to get back into the market and end up buying stocks at a higher price than what they sold them for.
A long-term investment allocation approach is the best investment strategy to have peace of mind and avoid losses. Warren Buffett has always recommended following the buy-and-hold strategy. He has stated that during a recession: “As long as you are invested appropriately for your goals, stay away from your investment portfolio.” As a long-term investor, you should plan to leave your investments alone for at least 7 to 10 years to see considerable gains.
Investment advisors will tell you to keep contributing to your 401k account when a recession hits. When the stock market is down, it is a great time to invest in your 401k. You might even consider increasing your automatic contribution amount because your investment can go further when stocks are down. This way, if prices continue to fall, you can take advantage and buy more.
Keep or Create a Diversified Portfolio
Hopefully, your investment portfolio is already well-diversified to reduce risk. If it is not diversified yet, it is time to start working on that. Consider investing in a wide range of sectors and industries. Low-cost index funds and ETFs offer effective diversification while reducing risk. Having a diversified portfolio will reduce your risk during a recession and improve your chances of gains when the market recovers.
Even though long-term capital preservation should be your main goal, if you have the funds when a recession is expected, you may want to invest in or re-allocate a small part of your portfolio to defensive, recession-proof assets discussed later in this article to lower your risk and keep your money safe. However, make sure that you buy these assets when their prices are still low and that you have an exit plan, so you know precisely when to move back to higher return assets.
Above All, Don’t Panic
It is easy to get obsessed with your portfolio when the economy is taking a turn for the worst, and the stock market shows a lot of volatility. Continuous checking on your investments’ decreasing value might send you in a state of panic and might make you consider getting out of the stock market altogether. Cashing out during a recession is by far the biggest mistake you can make during a recession.
Keep your long-term goals in mind. In some cases, the best thing to do may be to do nothing at all. If you have a diversified portfolio, trust the market’s resilience, and over time your portfolio will give you the returns you had planned for.
If you have enough money and the right attitude, it might be a good idea to invest during a recession. However, the bottom line is, you should never compromise your financial security for investments. If you are not financially strong, you can miss out on these opportunities and focus on your expenses to stay stress-free.
What Types of Investments Should Be Avoided?
Knowing what type of investments you should avoid is as important as knowing the best stocks and assets during a recession.
Cyclical stocks are stocks that move per the business cycle of an economy. A cyclical stock typically moves in the same direction as the economy. These stocks move up or down depending on the upward or downward movement in the economy. These stocks are usually very popular when investors try to buy them at the lowest point of a business cycle and try to sell them at their highest point.
They perform well during a bull market when consumer confidence is high, unemployment is low, and people are interested in spending money on luxury items. However, in a bear market, consumers will cut their spending on these discretionary luxuries, and cyclical stocks will decline in value. Therefore, cyclical stocks should be avoided during a recession. Examples of cyclical stocks are high-end cars, travel, and leisure activities.
Another type of stock to avoid during a recession is speculative stocks. Optimism among investors is put to the test during a recession. So speculative stocks perform the worst in these times because they are high-risk stocks that go up when the future looks bright and promising during an economic boom and fall fast in downturns when the future looks gloomy. Speculative stocks have not proven their value yet, so they will be abandoned in favor of recession-proof investments during a recession.
Stocks in High-Debt Companies
Investors should avoid highly leveraged companies during a recession. Such companies often suffer badly due to high interest payments and are often more vulnerable to tight conditions during a recession. A recession-induced reduction in revenue will definitely increase a highly leveraged company’s chance of bankruptcy.
Investment Strategies That Do Well During a Recession
Here are some of the proven strategies investors should adopt to reap benefits from the market conditions during a recession.
Dollar-cost averaging – One of the most powerful strategies for investors is dollar-cost averaging. When you follow this strategy, you invest equal amounts of money in the market at regular time intervals to reduce the impact of volatility on the overall purchase instead of simply investing a lump sum all at one time.
Instead of trying to time the market, you buy in at a range of different price points. Dollar-cost averaging works because, over the long term, asset prices tend to rise. This investment strategy takes the emotion out of investing because you regularly purchase the same small amount of an asset. When the prices are high, you get fewer shares, and when prices are low, you got more shares.
Even if you do not have a lot of money, dollar-cost averaging can help you begin investing with only a small amount of money. An example of dollar-cost averaging would be putting a fixed amount of money each month in an employer-sponsored 401K retirement plan or an Individual Retirement Account (IRA).
Fixed-income and dividend stocks – Income-yielding investments such as dividend stocks and fixed-income investments like treasury bonds are great investment choices during a recession because they provide routine cash payments.
Investing in companies that pay out dividends to shareholders in addition to regular earnings is a great way to deal with volatile market fluctuations and a down market. Another benefit of investing in dividend stocks and dividend ETFs is that the earnings can be reinvested. Even if the stock’s value is low because of the recession, the reinvested amount can offset the decline in value. Besides, companies that pay dividends are often relatively low-risk investments because they are usually well-established, strong companies with positive earnings year after year.
Bonds are attractive because of their periodic payments. Besides offering routine payments, treasury bonds are very safe investments during a recession because they carry the highest credit ratings and are backed by the U.S. government. The best part is that they often outperform during a recession and benefit when central banks cut interest rates.
Recession-proof sectors/defensive stocks – During a recession, some sectors perform better than others with the consumers’ changing needs. Stocks in these sectors are often called defensive stocks because their performance is stable during the whole economic cycle. In other words, they provide goods and services that people will buy regardless of the economy’s health.
They are also called counter-cyclical stocks because their stock price generally moves in the opposite direction of the prevailing economic trend. They increase in value during a recession, and they decrease in value when the economy starts expanding again.
Consumer Staples, Utilities, and Healthcare are usually the 3 best sectors to invest in during a declining economy. This is because, whatever the situation, people still need to buy essentials such as food, toiletries, and medical care and still need electricity to light their homes. Defensive stocks might not be attractive during economic booms. Still, they are good investment options for investing during a recession. These sectors generally don’t grow rapidly like others, but they survive the recession and recovery phases.
Consumer Staples is the largest defensive sector. The companies in this sector are very stable because they sell products that are always in demand. Many of them have been around for ages and have the ability to endure challenging economic times. The Consumer Staples sector includes companies like Proctor and Gamble and Coca-Cola.
The Utility sector is a safe sector to invest in during economic instability. Gas and electric companies’ pricing is often regulated, and therefore they have healthy profit margins. As they offer essential services to the public, the government will not let them fail. Companies like Exelon and Dominion Resources are companies in this sector.
Companies in the Healthcare sector are usually pretty safe investments because people will still need insurance and still get sick during a recession. Health insurers, health care providers, pharmaceutical companies, and other operations associated with the improvement of mind and body are part of this sector. Johnson & Johnson is a good example of a defensive stock.
Mutual funds that track specific sectors – Investing in low-cost index funds and Exchange Traded Funds expose you to fewer risks than other stocks. So ETFs and index funds are good investment options in a declining economy. When you invest in funds, you get exposure to various securities rather than a single stock. This is beneficial in a recession as you avoid concentrating the risk on a single company. Companies with strong performances in the fund can easily make up for the losses you might encounter from a poorly performing company in the fund.
Healthy companies – Those interested in individual stocks during a recession should look for stocks in overall healthy companies with good fundamentals and strong financials. Companies with strong balance sheets, low debts, a positive cash flow, and profitable operations are likely to get through difficult times. Look for the big players that have withstood past recessions and economic downturns and are still thriving.
Real estate – Real estate is a physical commodity that can make a smart investment during a recession. Property values decline in some markets, and mortgage interest rates tend to fall during a recession. Because there is a constant demand for real estate, but competition from investors during a recession is usually low, buying real estate at low prices can result in significant gains when real estate values start rising again when the economy recovers. Investing in real estate is a great long-term investment strategy during a recession.
Precious metals – Gold, silver, and other precious metals are great assets to invest in during a recession as they are in limited supply, and their value doesn’t depend on the stock market. These commodities generally perform well when the stock market is down. You can always rely on these assets when planning your investments for an upcoming downturn. Besides being safe investments, they reduce the volatility of your portfolio in the long term.
Investing for Recovery
Investors always need to pay attention to the economic cycle and adjust their strategies as the economy shifts from recession to recovery. Low interest rates and growth are signs of this market condition. Rising investor confidence leads to a boom in the economy during recovery.
Cyclical, speculative, and growth stocks that survived the recession are the best investment choices because they are the first to bounce back during recovery and offer the best earning potential. Rebalancing your portfolio with these stocks and funds while getting rid of some of the counter-cyclical stocks that will not perform well during a growing economy is a great investment strategy in an expanding economy.
A recession should not affect your long-term investment plans to a great extent. The key is to avoid panic, stay on track, and use effective defensive strategies to invest smartly during downturns. After all, a successful investment plan with a well-diversified portfolio is the one that is designed to withstand such volatility.
We hope these tips and information help you make smart investments during the recession. While recessions can be tough times, prepared investors should find lucrative opportunities with the right plan and risk management strategies.