Do you know when the next recession is coming? Or, perhaps more pressingly – do you know how to prepare your portfolio for when the recession inevitably occurs?
News headlines can be deceptive, even alarmist, in how they view the market. You yourself have probably seen it everywhere:
- “Another record high”
- “Historical Bull Run”
- “Dow 30k”
- “It can’t run at this rate forever”
With those types of headlines flashing in front of us daily, be it on our televisions, phones, or computers, it’s very natural to think: “When is the next recession coming?” And, in fact, preparing your portfolio for a recession now is one of the best moves you can make to ensure your financial future.
While the Great Recession occurred about a decade ago now, the wounds and mental scars are still very fresh. It’s natural, and probably wise, to be concerned about the implications of a recession.
The objective of this article is to serve as a guide for understanding recessions, how they can affect your portfolio, and how to properly position yourself for when one comes, eventually.
Before moving forward, FinancialProfessional.com wants to remind you that all of the content on this site is educational and informational in nature. It is not intended to serve as investment advice. Individual circumstances vary. Please consult a tax professional and licensed investment advisor for questions and guidance related to your specific situation.
Recessions Happen…Accept It
The first way to prepare your portfolio for a recession is understanding that recessions happen! In fact, they may be considered healthy in some regards (within reason, of course).
Capitalist economies work in cycles. They expand, reach a peak, contract (go into a recession), reach a trough, and go back to expanding. In fact, by definition, an economy goes into a recession when it experiences two consecutive quarters of decline in GDP.
Recessions happen for several reasons, but they usually occur due to the economy reaching its capacity. The Federal Reserve has actually been known to induce recessions in the past through monetary policy in order to stop the economy from overheating. While it may seem counterproductive in the short run, in the long run, it promotes the overall stability and health of a country’s economy.
Capitalizing On Recessions
While recessions may be frightening, they can also provide long-term investors with excellent opportunities to acquire assets and steeply discounted prices.
You may have heard the saying “buy low, sell high.” While that statement is much easier said than done in practice, that’s exactly what you’re doing when you put cash to work during steep declines in broader indices, such as the S&P 500.
For long term investors, steep declines should be seen as “stocks going on sale.” During periods of instability, many investors let their emotions take over, which causes them to sell their positions in a panic. Risky assets, like equities, are usually among the first to be sold off as investors flock to safety in “safer” assets like bonds or cash. All of this selling puts downward pressure on stock prices, creating potential “discounts.”
It took the stock market roughly 9 months to recover from its maximum drawdown during the GFC. The investors that panicked and sold at the lowest dips in the market saw their portfolio values vanish by about 40%. Had they held onto their positions (assuming their portfolio was comprised of Large Cap stocks), they would’ve made their money back – and much more – over the raging bull market leading up to 2020.
Again, all of this is much easier said than done in practice. In fact, many investors do “buy the dip” but then abandon their strategy when they see the market continuing to fall. Recessions vary in length and severity. You will only know when one is over in hindsight. This is why this stance requires a long-term perspective.
Clarify Your Financial Goals
As we continue to approach the next recession, it is imperative that you understand what you are investing for, which will help you better prepare your portfolio. Your financial goals provide you with clarity and context.
When you know what you are trying to accomplish, and how much time you have on your side, recessions are much less frightening. The retirees that were proactive and had balanced or conservative asset allocations before the GFC fared much better than the ones that were aggressively positioned towards equities. Chasing returns versus doing what was best in regard to your financial goals is a riskier strategy anyway, but the closer you are to retirement, the more you have to lose if the market fails you.
If you are a young investor, still in the accumulation phase, you know that a steep decline in the market will not make or break you because you have time to recover. That said, if you know that your financial goals are within reach, it may not make sense to be positioned in an overly aggressive manner.
Only you know what is best for you.
Take some time to review the financial goals you have laid out for yourself. Which one of them would be in jeopardy if the market took a big hit? Which goal(s) would still be intact?
It is usually wise to match your asset allocation with the amount of growth necessary to meet your financial goals, along with the time frame that you are giving yourself to meet said goals.
Build an Emergency Savings Fund
While it may not be related to your investment portfolio, having an emergency savings fund can be a lifesaver when it comes to preparing for and dealing with a recession.
Most financial experts define an emergency savings fund as an account that can get someone through at least 3-6 months’ worth of expenses in the case of financial hardship or an emergency.
The closer you are to relying on your portfolio for income, the more you should accumulate in your emergency fund. By the time you’re nearing retirement, you should have roughly 1 years’ worth of expenses saved up.
It is always best to be proactive when dealing with your personal finances and investments. That’s exactly what you’re doing when you have an emergency savings account fully funded.
The last thing you want to do during a recession is to be forced to sell investments. Selling investments during a period of steep market drawdown can take years off of a portfolio’s longevity.
Investing aside, an emergency savings fund can also help you avoid taking on excess debt. Remember, you want to be in the driver’s seat as much as possible.
If you do not have an emergency savings fund at this time, make it a priority to establish one.
Own Quality Names
Different investments react to periods of economic instability in different ways. If you are very concerned about an impending recession, you may want to prepare by owning quality investments in your portfolio.
“Quality” typically refers to well-established companies or “blue chips.” These companies tend to be much more mature than their sexier up-and-coming counterparts. They have more predictable lines of business and cash flows. They also tend to pay out dividends, which can be a crucial component of “surviving” a recession. Dividends can serve as a buffer against price volatility.
Quality companies are typically larger than newer, riskier companies. An easy way to determine the size of a company is through calculating its market capitalization. The way you do so is by multiplying its current share price by the number of outstanding shares.
While the shares of these companies are not bulletproof, they tend to hold their weight much more than shares of riskier, or more speculative companies that are still working towards gaining a foothold in their market.
Quality tends to lag during runaway bull markets (people are more interested in taking more risk). However, it tends to outperform during bear markets. Remember the quote: “it’s not about how much you make, but what you keep”.
Own Defensive Companies
Another important concept to understand in investing is “cyclical” vs “defensive” companies.
Cyclical stocks are those that tend to follow the business cycle. In other words, they perform very well when the economy is booming, but suffer when the tide turns. A classic example of a cyclical stock would be an airline. When recessions hit, people have less disposable income to take trips; which hurts the bottom line of the airline.
Defensive stocks are companies that offer products and services that consumers use regardless of economic conditions. They tend to lag during bull markets, but they usually hold their weight well when the economy contracts. Consumer staples, tobacco, and the like can fall into this category.
If you’re concerned about an upcoming recession, you may want prepare by considering some new defensive positions in your portfolio.
Diversify Your Portfolio
While diversification can limit returns, it can also potentially save you from blowing up your portfolio when things go south. The entire point of diversification is to limit the impacts of steep losses in any one stock, sector, country, or asset class.
Blackrock, for one, has a great study that shows the value of a holding a diversified portfolio throughout times of volatility.
Thinking globally can potentially be a great way of diversifying. While the last recession was global in nature, that is not always the case. Even if the next recession is felt on a global scale, some countries may feel the effects of it less than others.
Diversification across asset classes can also serve as a buffer. Fixed income and cash investments tend to be much “safer” than equities, especially during times of uncertainty. Alternatives like gold, real estate, etc. can also reduce portfolio volatility. This is largely because they do not always move in tandem with the stock market.
A diversified portfolio is one that has different parts, moving in different directions, at different times. Diversification will not make your portfolio invincible, but it will help you spread your risk across markets and asset classes. This makes it an excellent practice for those looking to prepare their portfolios for the next inevitable recession.
The News Is Not Your Friend
The last thing to consider as you prepare for the next recession is that the news will be a major distraction. Remember, news corporations are businesses, just like any other company in which you you invest.
How do they make their money? By appealing to human emotions. Unfortunately for investors, the two emotions that sell the most are fear and greed.
When we tip into the next recession, rest assured, the media will have a field day. The headlines will make you think the world is ending. If you pay attention, the news does this, even in the middle of a raging secular bull market.
Do not believe the hype. Use the news solely as an outlet to understand what is going on; but nothing more.
Remember that the news does not have your best interest in mind; they are appealing to the masses at large. The news does not know what your financial goals and circumstances are.
Anticipate this will happen. When it does, remain focused and disciplined. There will be a lot of people abandoning their strategies and plans solely due to what they see on the news. Do not let that be you.
A Final Word on Preparing Your Portfolio for Recession
While have seen some historical returns in recent years, it is wise to understand that it will not always be this way. Recessions, while discomforting, are a natural occurrence throughout the lifetime as investor. If you are a young investor, you will likely see several market cycles between now and when it is all said and done.
In preparing your portfolio for the next recession, keep in mind that these events provide long-term investors with excellent entry points. As markets rebounds, investors that took on calculated risks tend to be rewarded handsomely.
It is wise to be clear on what your financial goals are, and how a recession would affect them. If you have time to recover, the implications of a drop in the market matter much less. If you are approaching your goal(s), it may make sense to evaluate the risk you are taking in your portfolio to make sure it is appropriate.
Be proactive. Make sure you have a dedicated emergency savings fund so that your hand is not forced at an inopportune time.
Consider holding quality and defensive names; which tend to hold their weight better than their counterparts during recessions.
Diversification can help you spread your risk across markets and asset classes. Limiting the effects of a decline in one area of the market is critical to “surviving” recessions.
Lastly, do not let the media or news outlets lead you astray. The news profits off of human emotion. Stay focused and objective.
If you consider these principles and continue to do what is in your best interest, you will not only get through the next recession in one piece, you may even capitalize on it, like many great investors do.