Investing During a Recession
When the economy is down, it’s normal to question how you should be investing during a recession. Certain investments, such as stocks, can be riskier in economic downturns than in periods of growth. From January to July 2022, the S&P 500 fell 13.34%, the Nasdaq fell 20.66%, and the Dow Jones Industrial Average fell 9.61%.
While the stock market has had the worst first half of the year in the last 50 years, inflation has also climbed to 40-year highs with the June CPI reaching 9.1%, and US GDP contracting for the second quarter in a row. It can feel like there is no way to protect your portfolio.
However, investors may be able to see strong returns from a recession with the following strategies.
Investment Strategies for a Recession
Dollar-Cost Averaging (DCA)
Dollar-cost averaging is a strategy that can help investors deal with uncertain markets by making dollar amount purchases automatic. DCA simply means investing the same amount of money into target security or fund at regular intervals over a certain period of time, regardless of the price of the stock.
The idea of dollar-cost averaging is that an investor buys shares at higher prices when the economy is strong and at lower prices when the economy is in a financial crisis. Dollar-cost averaging helps by gradually reducing an investor’s overall cost basis in the share price. This helps during downturns because when the price rebounds, your cost basis is always lower than the price.
Investors can change the balance of their holdings when they notice stock prices begin to fall. Investors then can rebalance holdings or return asset allocation to its original targets.
For example, if your target balance is 60% stocks and 40% bonds, your stock position is likely lower and your bond position is higher during a recession. When you rebalance during a period of market growth, you’ll likely sell bonds and buy stocks to return to your target allocation.
Maintain Long-Term Goals
If you are purchasing stocks or mutual funds, you will likely not withdraw from your account(s) for at least five to ten years. For that reason, short-term market changes should not concern your overall goals.
It’s commonly recommended to concentrate on your initial investment strategies while markets fluctuate. Stock prices may be down, but that doesn’t mean investors must change the way in which they invest. Even during market turbulence, an individual investor’s own goals and risk tolerance should be considered.
How Do Assets Perform During a Recession
During recessions, it can be easy to let fear drive investment decisions and make calls based on short-term volatility. It is important to understand how certain assets and sectors commonly perform during a market downturn and how they are related.
Stock prices often fall months before a recession begins, because the stock market is a forward-looking indicator whereas economic reports are reviews of the past. This means that stock prices often bounce back before the recession is declared.
Stock prices tend to fall before a downturn begins and almost always before a recession is called. If a trader is looking to make use of lower prices, they will likely benefit most if they buy before the recession begins or in the early stages.
As during any period in the economic cycle, companies with stronger balance sheets are more likely to have strong long-term investment opportunities. Looking for dividend stocks can also be a way to ensure cash flow during market volatility.
Defensive sectors refer to those whose profits are not impacted as greatly throughout the economic cycle. Often defensive sectors are made up of companies that sell goods and services that people buy regardless of the state of the economy.
The consumer staples sector is the largest defensive sector. Even in a recession, people have basic needs, which means they are still buying food, medical supplies, and household goods. Companies that sell food products and other basic necessities tend to outperform other industries because of this.
Healthcare companies make up another defensive sector. Insurers, healthcare providers, and pharmaceutical companies all have little exposure to economic cycles. Even during a bear market, people get sick.
Utilities are also seen as a recession-proof sector because of the inelasticity of consumers’ need for electricity and gas. In addition to providing basic necessities, utility companies tend to have healthy margins and strong cash flows and are often supported by government stimulus and regulation.
The last defensive sector is, as you might have guessed, the defense sector. Defense companies are resilient to recession because their cash flow is heavily based on government contracts that are not related to the economy, but are instead based on long-term defense policies.
Prices for bonds tend to rise during a recession. The Federal Reserve stimulates the economy by lowering interest rates and purchasing treasury bonds. However, if a recession is met with rising inflation, as we’ve seen in 2022 so far, the Fed may increase interest rates which can push bond prices lower.
Different alternative assets will have varying performances during recessions, but some alternative assets have weathered recent recessions quite well. In general, hard assets act as strong stores of wealth because they have no intrinsic value and their value is not correlated with the stock market.
Real estate and commodities such as oil have long been seen as recession-proof assets, but many other alternatives beyond that work to help with portfolio diversification.
Rental real estate in particular often outperforms because of the passive income provided. With record-high prices keeping many would-be homebuyers out of the market, the rental market may stay hot throughout a recession.
Precious metals like gold and silver often see a hike in demand during stock market sell-offs because of their perception as stores of value. All hard assets fall into this category as well — contemporary art, jewelry, watches, and collectibles.
Risks of Investing in a Recession
Investing is risky during an economic expansion, and can be even riskier when the market is down. Timing the market to try and buy in at the bottom is nearly impossible, so this strategy is risky.
There is a phenomenon on wall street called the “bear market trap” which refers to investors getting caught up in short-term market optimism and making decisions based on recovery, only to see another fall in prices. It’s important to remember that markets can still face plenty of volatility, even if the economy has seemed to fully recover.
The main risk in investing during a recession compared to investing during expansion is liquidity and cash flow. If an investor loses their job during a recession, especially while inflation is high, they can suddenly require an outside source of income or liquidity.
The uncertainty surrounding the job market during recessions is something each investor should keep in mind while investing during down markets.
While investing during market volatility and economic uncertainty can be daunting, with a proper strategy and an appropriate risk tolerance, investing during a recession can be profitable. There are many industries that succeed during recessions and many individuals who successfully mitigate downsides.
One of the easiest steps to help hedge your investments against recessions is to diversify across assets that do not correlate with the stock market. Many alternative investments are the best performers during periods of economic downturn. Contemporary art, for example, has come out of the past three economic downturns with an average return of over 7% while the S&P 500 returned an average of -17%.
While purchasing a Basquiat for your living room may not be in the cards for many investors, Masterworks is the first platform making it possible to invest in multimillion-dollar works from artists like Banksy, Kaws, and Basquiat in fractional shares.
This material is provided for educational purposes only. It is not intended to be investment advice. Any examples discussed are purely hypothetical and do not reflect any actual investments.