Concerned about a recession? Here’s what you need to know
When the news is focused on high inflation, rising interest rates and an inversion of the yield curve, chances are the headlines are also debating the possibility of a coming economic recession. If you’ve never lived through one – and even if you have – all that recession talk can be worrying. But keep in mind that the economy is always fluctuating and that most recessions are relatively brief.
And there are strategies you can employ to help protect your investments during a recession. In this article, we discuss:
- What is a recession?
- How does a recession impact financial markets?
- How to protect your investments during a recession
What is a recession?
Though precise definitions differ, a “recession” is a pronounced economic decline, usually lasting at least two quarters in a row. Simply put, during a recession, trade and industrial activity decline, as does GDP, employment and retail sales.
During a recession, people tend to spend less on non-essential products and services, which impacts business revenues. More recently, inflation has been at decades-high levels, raising costs for consumers and businesses. As interest rates rise (to help tame high inflation), so does the cost of borrowing. These elements create an environment in which businesses tighten their financial belts, slow expansion plans and possibly lay off employees.
How does a recession impact financial markets?
Investor confidence often tends to decline – along with stock prices – during a recession. Thus, recessionary periods are often accompanied by a bear market. Some investors panic, rotating their money toward safer, less volatile assets such as government bonds.
The good news is that recessions don’t tend to last long, and eventually, the economy stabilizes and markets should get back to normal. The even better news is that not all sectors of the economy perform poorly during a recession. Some companies even thrive.
During a recession, though consumers and businesses reduce their spending, they still need to buy the necessities. Sectors and industries that provide staples, such as food, in the past have outperformed during a recession. People still need power and water, and so utilities have also tended to perform well in the past, as has health care. These sectors are known for being more defensive in a downturn.
le purchase fewer cars and other big-ticket items during a recession. The travel industry and luxury goods sales tend to decline. Fewer businesses make large expenditures on large technology projects, which negatively impacts those areas of the market.
During a recession, many investors become more risk averse. Therefore, asset classes that tend to have higher risk, such as stocks and commodities, have tended to perform poorly during recessionary periods. Other asset classes, such as gold and bonds, have performed better during recessions.
How to protect your portfolio during a recession
Recessions are an inevitable part of economic and market cycles but are difficult to predict. The last thing investors should try to do is attempt to shift around their portfolios in anticipation of the next economic cycle. Instead, you can help minimize your risk during a recession by ensuring that your investments are tailored to your financial goals, according to your risk tolerance and investment time horizon. (In other words, stay the course!)
Consider staying invested
It’s difficult to watch the value of your portfolio decline during a recession. But try not to panic. All investments fluctuate in value. If you sell your assets when they’re down, you could lose out on the potential gains when the markets eventually recover. You may want to consider staying invested for the recovery.
If you’re a newer investor, a recessionary period shouldn’t keep you from investing for your future. Invest according to your goals, risk tolerance and time horizon and it shouldn’t matter when you enter the market. Just keep investing regularly over time.
The best way to get through a recession is by having a diversified portfolio – one of the hallmarks of wise investing in any economic cycle. A diversified portfolio is more likely to recoup its losses when the economy recovers.
Diversification is important because all investments fluctuate – but at different times, in different environments, and in different degrees. It’s generally riskier to have all your investment returns rely on a single stock performing well. If that company’s industry declines, its stock generally will too, even if the company is doing well.
During a recession, when one industry underperforms (for example, travel), another will outperform (such as grocery stores). If you’re invested in a variety of companies, sectors and geographical regions, chances are your returns will be more even.
If you’re already invested in stocks, you might consider expanding your portfolio to include other asset classes, like bonds, or opt for easy diversification with the addition of an exchange-traded fund (ETF) or mutual fund rather than more individual stocks.
Over time, different assets within your portfolio perform differently. Some go up and some go down, and based on their performance, their weighting within your portfolio will change.
For example, if your target asset mix is 70% stocks and 30% bonds, and your stock holdings have outperformed, they may have shifted to be 85% of the value of your portfolio. That leaves your bond component at a 15% weighting. If the market suddenly shifts the other way, your portfolio is now overexposed to stock market declines and underexposed to the recovery in bond markets.
That’s why it’s important to revisit your investments periodically, to see if they need to be rebalanced back to your optimal portfolio asset mix. You may need to sell one type of investment to purchase another.
Shore up cash reserves
While they’re a good thing for everyone to have, the importance of an emergency fund for investors can’t be understated. It’s a critical buffer in the event of a market downturn. You don’t want to have to sell your investment when it’s low – you want to stay invested so that the asset has time to gain back its value when the market recovers. Similarly, if you’re retired or close to retirement, a cash reserve helps you avoid having to liquidate investments to meet your income requirements.
It’s no different when investing during a recession. A cash reserve acts as a critical buffer should you lose your job, or your investments underperform, leaving you less likely to have to sell when the market is on a low ebb. Importantly, a cash position also gives you greater ability to take advantage of investing opportunities along the way and profit from the recovery.
While it’s always difficult to watch your investments decline in a recession, try to remember that recessionary periods don’t tend to last for long and are usually followed by an extended period of recovery.
Stay focused on your long-term financial goals, make sure you’re investing according to your risk tolerance and goals, and try to set aside cash reserves to help lower your risk. It’ll also set you up to gain during the market recovery.