As the economy weakens, people pull money out of financial markets because they expect companies (and therefore their securities) to perform worse, they need the investment money for living expenses, or both. That causes the prices of stocks and other securities to fall. How prolonged and deep that fall is depends upon how bleak the economic data is and how much it shakes investor confidence. Recessions can impact your investments in the following ways:
Investment losses: A decline in financial markets can erode the value of your investments. For example, the Great Recession closely correlated with a big decline in the financial markets. The S&P 500 clocked a high of 1,576.09 in October 2007 and a low of 666.79 in March 2009— a drop of almost 58%. The NBER called the recession as happening between December 2007 and June 2009.Investment losses are not limited to just stocks. Other asset classes such as real estate get impacted too. If you count your home as an asset and the housing market crashes, you could end up with negative equity in your home. Loss of investment potential: Many people lose their jobs during a recession. Between December 2007 and 2008, unemployment jumped from less than 5% to 7.2% when 3.6 million people lost their jobs. Without a job to provide income, many people had to take money out of their portfolios to cover expenses, meaning they missed out on recovering their losses when the market recovered.They also missed out on investing more during the market downtrend adding to the loss of investment potential. Early tapping of retirement savings: Many workers, especially those nearing retirement, are forced into early retirement due to a job loss in a recession. That causes them to dip into their already reduced retirement savings sooner and for longer than they expected.It can go the other way too. If the erosion of your nest egg leaves you feeling that you don’t have enough tucked away for retirement, you could be forced to delay your retirement plans.
What To Do Before a Recession
Preparing for a recession is important not just for your investment portfolio, but your overall financial health. However, there are some steps you can take to get your portfolio ready to weather the storm.
Assess Your Finances
Taking a step back to look at your overall financial position may be a good starting point in insulating your investments from the impacts of a recession. While it may not be possible for everyone to adhere to it, Henry Gorecki, a Chicago-based CFP, recommends a budget where 70% goes toward meeting your necessities, 10% toward your retirement, 10% toward savings, and 10% is allocated to fun. Having some savings or an emergency fund can also help you meet your expenses in case of financial difficulties without selling your investments. It may also be a good practice to take this time to assess your risk appetite. Your risk tolerance will determine how much investment volatility you can stomach and which investment types you may be more comfortable with.
Diversify Your Investments
Diversifying your investments makes good sense even if a recession is not imminent. A well diversified portfolio consists of investments that don’t move in the same direction. That helps manage risk and losses. The value of one investment can rise while another falls on account of specific economic factors. Diversification also implies spreading your money across aggressive assets such as stocks while also investing in less volatile securities, such as bonds. Historically, bonds lose much less value during recessions and can help offset some of the losses in stocks. Asset classes such as gold are considered safe havens, or investments that investors flock to when stocks are on a downtrend.
Defensive Sector Allocation
Weighting your portfolio toward defensive sectors may help you limit losses during a market downturn. “The traditional advice is to push money toward ‘defensive’ sectors ahead of recessions—typically healthcare, consumer staples, and utilities,” said Riley Adams, a Louisiana-based CPA. “And on its face, it makes sense. When money’s tight, you can put off buying another pair of Lululemon leggings or a bigger TV, but you can’t stop spending on prescriptions, groceries, and electricity.”
Dividend Investing
Dividend investing is a great way to generate income from your investments. Companies often reward their shareholders by paying dividends. Investors can either take those dividends as income or reinvest them to build a greater position in the stock. Investing for dividends is a sound strategy even if the economy is doing well, but during a recession it can prove to be extremely beneficial because you can reinvest those dividends to buy more of the same stock at cheaper prices. Dividend paying stocks outperformed the broader markets during the 1981, 2001 and 2007 recessions, according data analysis by Morningstar. However, dividend-paying stocks underperformed the markets during the brief 2020 recession.
What To Do During a Recession
Investing during a recession can seem daunting, but the best thing for investors to do is stay the course and keep buying into the market. As Warren Buffett once said, it’s wise to be “fearful when others are greedy and greedy when others are fearful.”
Invest More As Stocks Decline
Though it sounds counter-intuitive, recessions give you the opportunity to buy shares in companies at prices much lower than their typical values. This is called buying the dip. It’s helpful because you’re not only getting a discount compared to normal values of these companies, you also stand the chance to make a greater profit when stock prices rebound. Having a well diversified portfolio lets you benefit from these low prices while minimizing the risk of any one company going under during a bad economy. Strategies such as dollar-cost averaging can help you ensure that you’re buying more when prices are low and reduce your average cost of investment. Periodic investments through automatic investment plans or Dividend Reinvestment Plans (DRIP) can help you make small stock investments even as markets continue to fall.
Rebalance If Necessary
In an environment where economic indicators are shaky and markets are generally trending down, chances are the balance of the assets in your portfolio will change as some securities decline more in value than others. Managing your portfolio during a recession also means assessing your investment performance and redistributing your money between sectors and asset classes if its not in sync with your risk tolerance and long-term investment goals. For example, if you’ve decided you want 15% of your portfolio in international stocks, and those stocks do so well compared to your other assets that their value grows past your 15% threshold, you may want to sell some of them and buy more in other sectors to hit your target allocations.
Consider a Real Estate Play
Another consideration is that interest rates tend to drop during recessions as the U.S. Federal Reserve aims to boost the money supply and help the economy recover. That can make recessions an appealing time to use leverage, such as by investing in real estate.
What To Tell Yourself If Things Get Bad
Here are a few good reminders to stop you from pressing the sell button as the markets turn sour.
Recessions and Bear Markets Don’t Last Forever
While recessions are scary, they don’t last forever. According to NBER data, the average length of a recession is 17 months. The shortest one occurred in 2020 and lasted only two months. Research also suggests that stocks may begin recovering from their losses even before the recession is officially declared over. And the upswings generally last much longer than the downturns. Lazard Asset Management analyzed 14 instances of bull and bear markets faced by the S&P 500 between 1926 and 2020. The average bear market lasted 20 months and saw a negative 41% return on average. The average bull market lasted 51 months with the index returning 162% on average.
Panic Selling Investments Is a Mistake
When you see the balances on your investment accounts plummet, its easy to think about cashing out to cut your losses. However, panic selling your investments doesn’t just leave you with losses, you also forgo any potential gains from when the markets recover. “Spend 15 minutes evaluating each holding—earnings expectations, recent news, valuations—and ask yourself, ‘Do I want to sell this for any other reason than the price has been going lower lately?’ If the answer is still yes, fine. But don’t let yourself panic-sell out of sheer fear,” said Adams.
