In this article, we will learn how to make your investments recession-resistant and protect them from the negative impacts of economic crises. We will cover many important points, such as how a recession affects your investments, what you should do before and during a recession, how to deal with bad situations, and frequently asked questions about this topic.
How a Recession Affects Your Investments
The National Bureau of Economic Research (NBER) determines when the U.S. economy is in a recession. A recession is defined as a “significant decline in economic activity that spreads across the economy and lasts more than a few months.”
As the economy weakens, people pull their money out of financial markets because they expect companies (and thus their securities) to perform worse, and they need investment money to cover living expenses, or both. This leads to a drop in stock prices and other securities. The duration and depth of this decline depend on how bad the economic data is and how shaken investor confidence is.
A recession can affect your investments in the following ways:
- Investment Loss: A decline in financial markets can erode the value of your investments. For example, the Great Recession was closely associated with a significant drop in financial markets. The S&P 500 index reached its peak in October 2007 at 1,576.09 and its lowest point in March 2009 at 666.79 – a drop of nearly 58%. The NBER described the recession as occurring between December 2007 and June 2009. Investment losses are not limited to stocks. Other asset classes like real estate are also affected. If you consider your home an asset and the real estate market collapses, you might find yourself with negative equity in your home.
- Loss of Investment Potential: Many people lose their jobs during a recession. Between December 2007 and 2008, the unemployment rate rose from below 5% to 7.2% when 3.6 million people lost their jobs. Without a job to provide income, many people had to withdraw money from their portfolios to cover expenses, meaning they missed out on recovering their losses when the markets rebounded. They also missed out on investing more during the market downturn, leading to a loss of investment potential.
- Early Use of Retirement Savings: Many workers, especially those nearing retirement, retire due to job loss during a recession. This forces them to tap into their already reduced retirement savings earlier and for longer than they expected. The opposite can also happen. If the erosion of your retirement nest egg makes you feel that you do not have enough for retirement, it may force you to delay your retirement plans.
What You Should Do Before a Recession
Preparing yourself for a recession is important not only for your investment portfolio but also for your overall financial health. However, there are some steps you can take to make your portfolio ready to weather the storm.
Evaluate Your Finances
The first step is to look at your overall financial situation and ensure that your investments are protected from the impacts of a recession. Henry Gorycki, a financial advisor in Chicago, recommends allocating 70% of your budget to meet your basic needs, 10% for retirement, 10% for savings, and 10% for entertainment. Having some savings or an emergency fund can also help cover your expenses in case of financial difficulties without having to sell your investments.
Diversify Your Investments
Diversifying your investments is a smart move even if a recession is not imminent. A diversified portfolio consists of investments that do not move in the same direction. This helps manage risk and losses. One investment’s price can rise while another’s falls due to specific economic factors. Diversification also means spreading your money across extreme assets like stocks, in addition to investing in less volatile securities like bonds. Historically, bonds tend to lose less value during a recession and can help offset some losses in stocks. Asset classes like gold are considered safe havens or investments that investors turn to when stocks are declining.
Asset Allocation
Defensive Sectors
Diversifying your portfolio into defensive sectors may help reduce losses during market downturns. Riley Adams, an accountant based in Louisiana, says, “The traditional advice is to direct funds toward ‘defensive’ sectors before a recession – typically healthcare, consumer staples, and utilities. At a glance, this makes sense. When money is tight, you can postpone buying another pair of Lululemon leggings or a bigger TV, but you can’t stop spending on prescriptions, food, and electricity.”
Investing in Dividends
Investing in dividends is a great way to generate income from your investments. Companies often reward their shareholders by paying dividends. Investors can take these dividends as income or reinvest them to build a larger position in the stock. Dividend investing is a sound strategy even if the economy is going well, but during a recession, it can be incredibly beneficial because you can reinvest those dividends to buy more of the same stock at lower prices. Analysis of data from Morningstar showed that dividend-paying stocks outperformed the broader markets during the recessions of 1981, 2001, and 2007. However, dividend-paying stocks underperformed the markets during the brief recession in 2020.
What You Should Do During a Recession
Investing during a recession may seem overwhelming, but the best thing investors can do is to avoid panic and continue investing in the market. As Warren Buffett said, the wisdom lies in being “fearful when others are greedy and greedy when others are fearful.”
Increase Investment When Stocks Are Down
Although it may seem counterintuitive, a recession presents an opportunity to buy stocks of companies at much lower prices than their normal values. This is called “buying the dip.” It is beneficial because you are not only getting a discount relative to the normal valuations of these companies, but you also have the potential for greater gains when stock prices rise. And if you have a well-diversified portfolio, you benefit from these lower prices while reducing the risk of any single company collapsing during a bad economic period.
Rebalance if Necessary
In an environment where economic indicators are unstable and markets are generally trending downward, it is likely that the asset balance in your portfolio may change as some securities decline in price more than others. Managing your portfolio during a recession also means evaluating the performance of your investments and reallocating your money among sectors and asset classes if they are not aligned with your risk tolerance and long-term investment goals. For example, if you decide you want 15% of your portfolio in international stocks, and those stocks are performing well compared to your other assets causing them to grow beyond the allowable limit of 15%, you might want to sell…
Source: https://www.thebalancemoney.com/how-to-recession-proof-your-investments-7096230
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