How To Invest During a Recession
Investing during a recession might lead you to attempt to time the market when stock prices are low and falling, hoping that stocks will rebound quickly. However, the most effective way to manage your money in a recession can depend on several factors, including your risk tolerance and time horizon, meaning how long until you need access to the money.
Dollar-Cost Averaging (DCA)
Whether you’re regularly contributing to a 401(k) or an individual retirement account (IRA) or investing in a non-retirement account through your broker, it might be wise to continue doing so during a recession. The strategy of dollar-cost averaging allows you to invest the same dollar amount consistently, whether the market is trending up or down. As a result, you would buy more shares of a stock when the stock price is lower and fewer shares when the price is higher. The table below shows an example of an investor buying $1,000 of a stock each quarter for one year.
Total amount invested = $4,000Total number of shares bought = 99Average share price = $46.25 or ($50 + $70 + $40 + $25 = $185) and $185 ÷ 4 = $46.25
The average price paid for the stock is lower than the initial price due to the down market. So, if the stock rebounds back to $50, the investor would have a gain of $3.75 or 8% or ($50 - $46.25) = $3.75 and ($3.75 ÷ $46.25 = .08 x 100 = 8%). As a result, dollar cost averaging can boost returns in the long run if the market rebounds.
Rebalance Your Portfolio
You can change the balance of your holdings when you notice prices falling. You then rebalance your holdings or return your asset allocation to its original targets. For example, if your target balance is 60% stocks and 40% bonds, your stock portion would decrease in a recession if the stock market declined, while your bond portion would increase. Let’s say that you started with a 60% equity and 40% bond allocation for a total investment of $10,000:
Stock portfolio value: $6,000 (60% of your portfolio)Bond portfolio value: $4,000 (40% of your portfolio)
The stock market declines while the bond market increases, changing your allocation to the following:
Stock portfolio value: $4,500 (45% of your portfolio)Bond portfolio value: $5,500 (55% of your portfolio)
To rebalance, you’d sell $1,500 of your bond portfolio and add that sum to your equity portfolio, which would bring your portfolio back to $6,000 in equities and $4,000 in bonds. Conversely, when you rebalance during an expansionary phase, you’ll sell bonds and buy stocks to return to your target allocation.
Keep a Long-Term View
If you’re buying stocks or stock mutual funds, likely, you won’t need to withdraw from your account(s) for at least five years to ten years. For that reason, you shouldn’t worry too much about short-term market changes. However, if you need to access the funds sooner, such as to pay for your child’s college tuition in the next year or two, you’d have to allocate enough money into bonds or cash leading up to the first year of college. In other words, you don’t want to be withdrawing money from your equity portfolio when the stock market is down since it can deplete your savings. Setting money aside for the first few years of retirement, college, or an emergency fund can provide you with cash when you need it, which helps you avoid dealing with market fluctuations.
Don’t Discard Your Strategy During a Recession
Stock prices might be down, but that doesn’t mean you need to change the way you invest. This thought process applies to long-term investors, short-term investors, and retirees.
Long-Term Investors
If you’re regularly adding funds to a long-term account, such as a 401(k) or IRA, don’t stop during a recession. If you place most of your money in stocks, don’t “chase performance” and sell out of them. They may be falling in price while bonds are rising in price. If that is the case, you could lose more money than if you were to stay in stocks. If you have chosen your stocks and funds with care, you will end up with more than you started with. Stay the course.
Short-Term Investors and Retirees
Although you may be uncomfortable during a bear market, don’t be tempted to sell your stocks or stock mutual funds at a loss. If you need income right away, it would be best to have money set aside in cash and bonds before the downturn. That way, you can withdraw from your cash while you wait for stock prices to recover.
Take on as Much Risk as Your Tolerance Allows
If you want to make good use of a market correction during a recession, try not to buy more stocks than you would during better times. If your risk tolerance allows you to accept a moderate asset allocation of 65% stocks and 35% bonds, you should keep that target, no matter what the market is doing.
Investing Before and During a Recession
It’s easy to go wrong during a recession if you forget or don’t understand how certain investments perform during a downturn and how they are related. Stock prices often fall months before a recession begins, which also means that they often bounce back up before the recession is declared over. You can miss an entire downturn if you only follow the news. That is why it is vital to know the signs of a recession and recovery and how assets perform during those periods:
Stocks: Prices for stocks tend to fall before the downturn begins and almost always before a recession is called. If you’re trying to make use of lower prices, you’ll likely benefit most if you buy before the recession starts or during its early phase. Also, stocks that pay cash dividends can provide income, which can help offset some market losses in your portfolio. Bonds: Prices for bonds tend to rise during a recession. The Federal Reserve (the Fed) stimulates the economy through quantitive easing by lowering interest rates and purchasing Treasury bonds. Cash/deposit accounts: Since interest rates fall from the Fed’s actions, they tend to do so on deposit accounts as well. However, cash and insured accounts are free from market risk, unlike bonds and stocks. Real estate: Home prices tend to increase when the economy is growing and decline during recessions. Owning a rental property can provide owners with a steady monthly income from tenants even in recessionary periods. However, real estate markets can decline, as was the case during the financial crisis of 2007 and 2008 and the resulting Great Recession. Gold: Most investors see gold as a haven. The price of gold often rises as markets plunge. Investors begin buying stocks again when things are looking up and sell their gold. That pulls gold prices back down again in another mass sell-off.
Risks Vs. Gains of Investing in a Recession
Stocks, stock mutual funds, and ETFs are risky during an expansion. They are even more so during a recession. It helps to compare the gains and risks of buying stocks during a downturn.
Gains
Before and early in a recession, stock prices often fall, making it a good time to buy. If you’re one who continues to dollar-cost average into your 401(k) plan, IRA, or other investment accounts, buying as stock prices fall pays off in the long run.
Risks
Timing the market and trying to buy when prices are low or beginning to recover is risky. You can still face lots of volatility, even if the market seems to have fully recovered. This is called a “bear market rally” or “bull traps.” You can get caught up in the optimism of the moment, only to see another fall in prices after the short-term rise.
The Bottom Line
Certain investments have performed in similar ways during recessions of the past. However, no one can predict what will happen in the market in the near term. Stock prices can suffer a large fall over one month, then rise again the next month, only to fall again a month later. Since no one can predict what the stock market will do and how people will react in the short term, it’s wise to commit to your investment strategy during a market downturn so you can participate in the recovery.
