Should You Prepare Your Investment Portfolio for a Recession?
As the news of a potential recession continues to dominate headlines and social media feeds, it's natural for investors to feel concerned about the potential impact on their portfolios. While selling off assets or restructuring your portfolio in anticipation of inflation seems like the obvious course of action, these approaches may not always lead to the best long-term results. Knee-jerk reactions to economic downturns can often be detrimental rather than helpful.
In this article, we'll go over how to navigate recessions and consider the factors investors should consider when facing uncertain times. By taking a deep breath and approaching the situation with a clear and level-headed mindset, you can avoid hasty emotional decisions and protect or potentially grow your portfolio during a recession.
What is a Recession
A recession is a period of a broad sustained decline in economic activity, characterized by falling levels of production, employment, and trade. It's typically defined as a decline in a country's gross domestic product (GDP) for two consecutive quarters.
While recessions can be disruptive and harm individuals and businesses, they are completely normal and play an important role in the economy's health. They help adjust imbalances, reduce inflation, and facilitate future economic growth.
Recessions can deflate asset bubbles by adjusting the price of assets that become inflated beyond their fundamental value. Recessions may force businesses to close or restructure, freeing up resources and capital that can be reallocated toward more efficient and effective projects. New technologies and business models can emerge during a recession, which can drive innovation and increase the efficiency of the economy.
But recessions are rarely good for individuals, and naturally, people do not have positive feelings about them. In the hope of protecting their portfolios, people are tempted to sell their investments and wait out the uncertainty or re-allocate their holdings to protect their wealth. In other words, people try to time the market or attempt to recession-proof their portfolios.
Timing the Market
During market downturns, it's not uncommon for people to panic and sell their investments to avoid further losses. In extreme scenarios, many investors try to time the market by selling all investments and waiting for the uncertain economic conditions to improve before re-entering the market. As a result, some people end up selling at market bottoms, when prices are at their lowest and buying at market tops, when prices are already high. While this can be an appealing approach for those who have already lost a significant amount of money and can't bear the thought of losing anymore, it often tends to be a losing strategy.
The market returns are often determined by just a few days in the year, and the risk of missing these best-performing days outweighs the benefit of waiting out economic downturns. Obviously, avoiding the worst trading days in the market would result in a better return on your investments. But again, accurately timing the market for any event is nearly impossible, even for professional investors. Numerous studies have shown that it's extremely difficult to perfectly time your investments, as it's unfeasible to predict how the multitude of interconnected economic factors will affect the performance of your portfolio.
Warren Buffett, the legendary investor and CEO of Berkshire Hathaway, is known for advocating a long-term investment approach. He has often warned against trying to time the market, stating that it's impossible to predict short-term market movements and that attempting to do so can be costly. He advises investors to be patient, keep their emotions in check, and avoid attempts to outguess market movements.
If timing the market doesn't work for most retail investors, maybe there is a way to recession-proof a portfolio.
Recession-Proofing a Portfolio
Investing in safe havens is a popular idea that some investors use to protect their portfolios from market fluctuations and economic downturns. Gold, Treasury bills, defensive stocks, and fine art are often considered less risky than stocks and other more volatile assets because they can be less correlated with the stock market.
While allocating some of your portfolio towards these assets to better diversify your risk may work in your situation - these assets won't necessarily insulate you from recessions. While safe-haven assets may maintain a low price correlation with stocks during times of economic stability, they can still be affected by market fluctuations and economic events, especially during downturns.
During times of economic uncertainty, investors may flock to safe-haven assets as a way to protect their wealth. This can lead to an increase in demand for these assets and a corresponding increase in their price. Contrarily, during times of economic stability, investor demand for safe-haven assets may decrease, leading to a decline in their price.
Some types of businesses may indeed be more recession-resistant than others, as they may provide essential goods and services that are less likely to be affected by economic downturns. However, similarly to timing the market, it's difficult to accurately predict which businesses will perform well during a recession. Trying to sell out of underperforming areas of the market and buy into outperformers can be risky because it requires making accurate predictions about the future performance of the market, certain sectors, and individual stocks.
Moreover, the stock market is not always a reliable indicator of the overall state of the economy. Retail investors may not always have a complete or timely understanding of economic conditions, including recessions. Average investors may only become aware of a recession after it's well underway or when the economy has started to recover from it.
While investors need to consider the potential risks and uncertainties, attempting to recession-proof their portfolios may be a futile exercise. It's impossible to predict exactly when a recession will occur or how severe it will be. It's also important to realize that no investment is completely risk-free and that all investments carry some level of risk.
How to Prepare Your Portfolio for a Recession?
Although you should regularly review and rebalance your portfolio to ensure it's still aligned with your long-term financial goals and risk tolerance - you shouldn't build your investment strategy around whether or not we will have a recession. The time to prepare for a market downturn isn't when it's imminent. Be always ready through the implementation of a consistent and risk-managed approach to investing. First, review the risk that you are currently taking on with your portfolio. Do you have a strategy, or are you taking a gamble?
If you are consistently applying a strategy that involves diversifying your portfolio with both stable and growth-oriented investments, limiting speculation, and thoroughly understanding the investments you make - you may not need to make any changes to prepare for a recession. Historically, recessions have been temporary economic setbacks, but the stock market has bounced back every time and delivered strong returns over the long term.
If you are not following the fundamentals of investing and are treating investing as a gamble, it may be time to reassess your approach. In that case, you may need to diversify or re-allocate your holdings. But don't make any hasty decisions. If you are unsure what to do, consult with a financial advisor or professional before making significant changes to your portfolio.
Related: Developing Your Investment Strategy
Don't Act on Emotions
Investment decisions based on emotions, rather than on a rational analysis of the risks and potential returns of an investment, can lead to poor financial outcomes. Research has shown that individual investors often underperform the market not because they make poor investment decisions, but because they buy and sell their investments at inopportune times.
Before making any investment decisions, consider your financial goals, risk tolerance, and time horizon. These factors can help you determine whether you should be invested, where to invest and to what extent.
Read more: Emotional Investing Can Cost You: What It is and How to Avoid It
An investment portfolio should not be designed for one particular event, like a recession. Proper diversification can help protect a portfolio against a variety of economic events, such as economic downturns, market volatility, or sector-specific risks.
Spreading out your investments across a variety of asset classes, such as stocks, bonds, and cash equivalents, rather than putting all your eggs in one basket, can help mitigate the risk of losing money in any one specific investment, as the performance of one asset class may not be affected in the same way as another by economic events. You can achieve diversification for any risk tolerance level, whether you are seeking growth or simply want to preserve your savings.
For an investor with a high-risk tolerance, a portfolio consisting entirely of stocks may be appropriate. However, even for this investor, diversification can still be achieved by investing in a range of various types of businesses, including those in different sectors and industries, as well as stocks from different countries.
For an investor with a moderate risk tolerance, a portfolio with a mix of stocks and bonds may be a good option. This mix can provide the potential for higher returns from stocks while offering some stability and income through bonds.
For an investor with a low-risk tolerance, a portfolio consisting primarily of safer investments such as bonds and cash equivalents may be appropriate. This allocation can provide a steady stream of income, but may not offer as much potential for growth as a portfolio with a higher proportion of stocks.
Consider your risk tolerance and financial goals when building a diversified portfolio. Consult with a financial professional if you are uncertain about what investments may be right for you.
Read more: Diversification: Important Concept in Investment Management
Don't Let Anxiety Stop You From Investing
It is natural to feel uncertain and hesitant about investing in times of economic turmoil, and some may be tempted to stop their contributions to their investments altogether. However, remember that uncertain times can sometimes present opportunities for investors to make good returns. While economic downturns can be unpredictable and may cause short-term market volatility, they can also create buying opportunities for investors with a long-term horizon.
During times of uncertainty, the prices of some investments may be lower than their intrinsic value. This prospect can be attractive for investors willing to take a risk and believe that the market will eventually recover. By purchasing assets at a discounted price, they may realize a good return when the market rebounds.