Surging inflation, rising interest rates, and stock market volatility have led many investors to assume that a recession is coming. The alarms have been sounding for a while now, particularly after gross domestic product (GDP) declined for two consecutive quarters in the summer of 2022. Nobody knows what will happen next, although there is a growing belief among economists that 2023 could be the year that the U.S. spins into a full-blown recession.
In an October 2022 survey by the National Association for Business Economics, more than half of respondents said the U.S. is likely to enter a recession in the next 12 months. That view is shared by the World Bank, which reckons that hiking interest rates to combat inflation will push the economy over the edge in 2023.
Investors shouldn’t let this scare them. Yes, recessions are not nice. However, they don’t last forever and most asset prices tend to recover and continue their upward trajectory once the economy is back on track again.
Still, it doesn’t hurt to consider how best to prepare your portfolio for an economic shock. Here are four ways to help set your mind at rest and be covered for all scenarios.
- Recessions don’t last forever. Most asset prices tend to recover and continue their ascent once the economy is back on track again.
- Defensive stocks are better built to withstand a recession and the quality ones usually offer decent dividends that can add up over time.
- Recessions serve as a reminder of the importance of owning various investments across different asset classes and regions of the world.
- Dollar-cost averaging can pay off during an economic downturn by reducing the average purchase price.
- If you have built a well-balanced portfolio, stick by it and don’t check it every day to see how much it is losing.
Invest in Quality, Cash-Rich Defensive Stocks
Not all sectors of the economy are the same. Certain types of businesses tend to struggle during a recession, while others are better built to withstand them.
Stocks are generally placed in one of two categories: cyclical or defensive. Cyclical means they are sensitive to the health of the economy, excelling when there is growth and struggling when everything slows down. Defensive is the opposite. These stocks, in theory, offer stability through all phases of the business cycle.
How do they achieve that? By generally being well-run, possessing strong pricing power, and supplying products that consumers either cannot or do not want to live without, such as water, electricity, food, and essential household products like toilet paper.
Defensive companies, which are mainly associated with the consumer staples and utilities sectors, are good to own. Other than being less volatile and sensitive to economic downturns, they also tend to generate lots of cash and pay decent dividends.
Income investments, in general, are an important component of a well-rounded, balanced portfolio and add significant value over the years when dividend proceeds are reinvested. Dividends can offer a nice cushion against stock price depreciation, too, provided the balance sheet doesn’t become too stretched and there’s enough money to continue to fund them.
During recessions, you want to own high-quality assets that keep making money, generate lots of cash, and have robust balance sheets. Avoid companies with lots of debt as a slowdown in revenues and changing credit conditions could spell trouble for them.
Diversify: Don’t Put All Your Eggs in One Basket
When the economy is booming, holding growth stocks can really pay off. But these types of companies are likely to perform poorly when growth in the economy slows or turns negative. When there’s a recession, investors can really begin to appreciate diversification by owning investments across different asset classes.
We’re not just talking about less racy stocks. To build a portfolio truly capable of weathering any type of situation, you ideally need to add some government and investment-grade corporate bonds, money market instruments, and maybe even gold. That’s especially the case when you’re nearing retirement or need the money you’ve invested soon.
Each asset class tends to behave differently. For example, historically, while stocks have done well when the economy is expanding, bonds often do the opposite, outperforming during recessions. This inverse relationship means the two can complement each other and essentially ensure that, no matter the economic climate, at least part of your investment portfolio will grow in value—or not get completely clobbered.
International exposure is also important. While the economies of the world’s nations are increasingly interlinked, there can be exceptions and regions offering slightly better growth prospects in any given moment.
If you don’t feel comfortable building a well-balanced, diversified portfolio, consider enlisting the help of a financial advisor or asset manager.
Recessions present a great opportunity to profit from dollar-cost averaging, which is basically the process of automatically buying investments at regular intervals, such as when you get paid.
This strategy makes the purchase price less essential and reduces the importance of getting the timing right. It also means that you can profit from a recession by buying shares or assets at lower prices. Many investors make the mistake of buying high and selling low. With dollar-cost averaging, it’s all automatic and you get the chance to top up holdings when they are at their most undesirable and cheapest.
One common complaint is that regular buying restricts potential upside when markets are trending upwards. However, some would say that’s a fair price to pay for the option of spreading out payments and limiting volatility.
Stick to the Plan and Don’t Panic
The above tips can help you build a portfolio to weather any storm. Beyond that, the best piece of advice on how to protect yourself against a recession is not to panic.
A popular opinion shared by many of the world’s greatest investors is to refrain from keeping regular tabs on the performance of holdings. When the markets are in the red and your losses seem to mount, it can be tempting to want to cut losses by exiting your positions. But, if you built your portfolio for the long-term, you should stay the course and ignore the voice in your head that tells you to be fearful.
Long-term, buy-and-hold investors should stick to their guns and not let short-term market noise push them off course.
It’s important to remember that most assets will recover and eventually continue their upward trajectory. If you look at the performance of the S&P 500 over time, you’ll see it keeps moving up, occasionally dips, and then moves even higher than before.
Long-term investing is a marathon, not a sprint. Think carefully about how to build a well-balanced portfolio, get advice when needed, and then once you’ve settled on how you want to invest, sit back, be patient, and stand by your conviction.
During a recession, it might all seem doom and gloom. But if you’ve selected the right blend of assets with long-term growth prospects, the right income profile, and so on, you should eventually be rewarded.
What Stocks Do Well During Recessions?
It’s very rare for individual share prices to rise during a huge market sell-off. However, there are companies that tend to shed less value and perform better than others. The outperformers are generally those with pricing power and limited competitive pressures who supply the population with goods and services they cannot live without. Examples include consumer staples and utilities.
What Falls Most in a Recession?
Highly cyclical industries and companies with lots of debt suffer more than others during a recession. Sectors that can be hit more severely include real estate, restaurants, hotel chains, airlines, autos, and manufacturing. When money is in short supply and people are scared to spend, demand for those types of non-essential goods and services tends to dry up.
What Should I Do During a Recession?
Outside of investing, it generally pays to be more prudent with spending and prepare for the reality that you could lose your job. Put as much money aside as possible and try to avoid selling your long-term investments.
The Bottom Line
Sadly, recessions are inevitable. It’s not always easy to get the timing right but what we do know is that every x amount of years the economy repeats a cycle, going from boom to bust and back again.
These difficult moments are important for investors to be aware of and can help us to make smarter decisions regarding how to behave and what to invest in. It’s pivotal to be prepared for any scenario as things can quickly and unexpectedly go south, as we saw in 2020, 2008, and countless other downturns in the past.
Recessions aren’t nice and your portfolio will likely take a bit of a battering during this period. However, if you follow the advice in this article, you’ll at least stand a greater chance of weathering the storm, reducing volatility, sleeping better at night, and reaching your financial objectives.