Investing in a RecessionBy: Henyl Williams, Branch Manager- Kingston Posted:
In the word of legendary Mutual Fund Manager Peter Lynch – “You get recessions, you have stock market declines. If you don’t understand that that’s going to happen, then you’re not ready, you won’t do well in the markets.”
We will first explore some key concepts such as defining what a recession is and the frequently utilised investment term– diversification, following which we will discuss what investors should do during a recession.
A recession is loosely viewed as a decline in economic activity. Typically, the core economic theories that focus on financial, psychological and what we will term real economic factors that can lead to the systematic flow of business failures, are what constitute a recession.
The financial factors that contribute to an economy’s fall into a recession includes rates that have been artificially repressed. As rates increase, this pushes up the cost of borrowing which in turn reduces demand. So high interest rates act as a deterrent to borrowing and investment. Secondly, the changes in economic fundamentals, which we will refer to as disruptions in supply chains and the eventual damage they can cause to a wide range of businesses. Shocks that impact key industries such as energy or transportation can have such widespread effects that they cause many businesses across the economy to make cuts, cancel investment and hiring plans simultaneously, which in turn has a contagion effect on workers, consumers and the stock market.
Thirdly, psychology-based hypotheses of recession generally examine the unwarranted exuberance of the preceding boom time or the profound pessimism of the recessionary environment for explaining why recessions can occur and even persist, what we term “speaking it into being” where the doom and gloom of investors appear to manifest itself into a self-fulfilling prophecy. This is characterised by curtailed investment spending based on market pessimism and scepticism, which then leads to decreased incomes that decrease consumption spending.
A recession may present itself as a crisis, however a crisis presents itself as an opportunity. One technique that an investor should put in place during an economic recession is diversification. Typically, a diversified portfolio has a mixture of stocks, fixed income, cash and real estate. This mixture of investment instruments is ideal because these assets react differently to the same economic event.
Both a long term and short-term perspective should be adopted when choosing to invest during a recession. Over the long term, your portfolio must be able to weather unexpected recessions and volatility. In the short term, when the probability of a recession is high, you will be looking to move part of your portfolio into recession-proof investment. Splitting your investments allows you to balance the risk/reward of your portfolio. Investments in Defense, Value and Dividend stocks is one such approach. Defense companies are defensive in nature, as their contracts are not related to the economy, but to long term defense policies and sectors.
Stocks with attractive dividend yields and high dividend ratios can be very effective recession-proof investments. Companies that pay dividends are cash rich which means risk is lower. Additionally, dividend stocks work for investors seeking out passive income which is money they earn consistently with little or no effort on their part. Value stocks are regarded as recession-proof investments simply because they have minimal downside as they are priced closer to their intrinsic value. These stocks make sense when investing during a recession, however one should not choose these stocks solely based on a low price-to-earnings ratio (PE ratio). Just because a stock appears cheap, does not make it a good investment.
Fixed Income assets – referred to as bonds help with mitigating risk and protecting investment capital in a recession because typically, they don’t depreciate in the same way as stocks. In a volatile market there is fluctuation in bond prices, but high-quality bonds tend not to experience price volatility like in the stock market. Investment in quality fixed income bonds tend to either go flat or up in general.
An economic slowdown does present opportunities to buy real estate since this investment speaks to a variety of investor needs, including diversification and income generation.
Lastly, one cannot underscore the need for accessible cash. It lowers the volatility of the investor’s portfolio and most importantly places one in a position to access investment opportunities when the correction slows.
Therefore, we see that in an economic recession there is an overall decline typically characterised by a drop in the stock market, an increase in unemployment, and a falloff in the housing market.
The assets mentioned above should be considered when a recession is likely or underway.
Economies are cyclical and markets will recover. The world of investing can be cold and hard but can be demystified. Thorough research, support of credible advisors and exercising patience, your chances of long-term success are good.