Recessions are a tough business. No matter what our instincts or advisors may tell us, chances are that our investments will suffer during a recession, whether we're too late in getting out of them, or too late to get back in. Below we expose some of the prevailing myths about recession investing, which carry one common theme among them: recessions are quite deft at rewriting old rules and breaking old patterns.
Myth No.1 - I need to be in the safest stocks to make any money.
This myth is only true before the recession takes hold. Safer, defensive stocks will tend to decline less than more cyclical names like financials, basic materials and retail stocks. But once the recession is in, the "safe" stocks may actually underperform because as soon as the market begins to rally forward again, it will be the most beaten down names that rise the fastest. So while that steady grocery store stock you held all the way through the recession may go up 10%, the beaten down bank stock may run 50% during a rebound.
So remember, once the recession is in, the most important decision is whether or not to be in the market at all (asset allocation). Once that choice is made, it's generally best to stay the course by participating in the broad market.
Myth No.2 - Bonds are the safest place to be.
This is not necessarily true. Bond prices move in the opposite direction of yields, so if you hold individual bonds and the rate of inflation rises dramatically (which can occur coming out of a recession), the price of your individual bond may drop 10% or more, but you only get the same amount of income as you did in the prior year.
The solution? Consider a mutual fund or ETF that holds hundreds of individual issues to smooth this out. Also, avoid longer-maturity bonds, which tend to be more volatile when interest rates move higher. (When the economy blows up, these funds offer some protection from major losses. Check out Recession-Proof Mutual Funds.)
Myth No.3 - When the stock market rises, the recession is over.
The stock market always tries to be a forward-looking mechanism. It will try to anticipate the end of a recession long before it can be confirmed through economic data such as GDP. Sometimes the market gets it right, but sometimes it doesn't, meaning that the stock market could initially rally only to falter again as the recession proves more stubborn and lengthy than first imagined.
Myth No.4 - Decoupling has made some countries safer investments during a recession.
Decoupling implies that growing economies in places like Asia and South America have developed to the point where they can continue to thrive even if the Western economies suffer a recession. This theme was proven false during our current recession, as nearly every market on the globe suffered equally.
While the developing economies may indeed be able to grow modestly while the U.S. and Europe suffer more, these developing nations need strong trading partners and the ability to export their goods to the western world.
Myth No.5 - Real estate is a safe place to be during a recession
It's barely worth mentioning how false this myth was proven during our current recession. A common symptom of economic malaise is deflation, whereby the prices of goods fall because there is too much supply and not enough core demand to support current prices. Real estate is no different; it's just another asset that can suffer from boom and bust cycles.
In our current crisis real estate happened to be the trigger of the recession, as years of heavy home building activity screeched to a halt and inventories rose dramatically, leading to prices falling 30% or more. (Follow these five tips to get a leg up on rival bargain hunters. Read 5 Tips For Recession House Hunters.)
Myth No.6 - Dividend stocks don't fall as much during a recession
A company that pays a healthy dividend can only do so when they have enough net income to spare some of it. In healthy economic times, a company may only have to pay out 20-30% of its net income as a dividend - a healthy cushion of preservation. But when a recession hits, company net income may fall by 50% or more, putting that dividend payment in jeopardy.
Because of this, dividend stocks may have two sources of downward pressure on their stock prices during a recession. The first is the prospect of lower profits, and the second is the fear amongst investors that the dividend may be cut or eliminated, removing one of the stock's main attractors.
The Bottom Line
Investing during a recession is a humbling experience. Many well-respected money managers had the worst year of their careers in 2008, proof that even those most familiar with the markets can be caught completely off guard.
The best advice one can give during a recession is to take the time to revisit your long-term goals, and adjust your overall asset allocation to protect current assets. Be willing to accept flat to small returns for a year or two if you already have a nest egg built up and are nearing major life goals.
For younger investors, continue to dollar-cost average into your diversified investments, and be thankful that you can buy up some assets that were once expensive at a cheaper price. In time, the market should reward your patient, diligent approach.
To learn more about the recession and how to cope with it, read Recession: What Does It Mean To Investors?