How to Adjust Your Investment Portfolio for a Recession
Whenever the U.S. economy is doing extremely well for long periods of time, there will be pundits that caution the next recession, which may be lurking around the corner.
The most dramatic sound bites make it sound as if the economy is about to fall off a cliff, and that stocks are going to crash right along with it.
Of course, an old joke about economists is that they have predicted 10 of the last six recessions.
The truth of the matter is that it’s difficult to predict with any accuracy when the next recession is coming.
And there is always something to worry about when it comes to the economy and the stock market.
As a result, most experts recommend that you stay the course with your investments and not try to time the market.
Of course, some investors just can’t handle the thought of a significant loss in their portfolio, even if it is only temporary.
If the thought of an upcoming recession is making you anxious, here are some things to consider.
Asset Allocation and Risk Tolerance
Your investment portfolio should be constructed in line with your investment objectives.
If your goal is to generate capital gains, you should include a significant stock component in your portfolio.
If you want to earn income, bonds should be a portfolio cornerstone.
However, there’s another step in constructing a portfolio that’s equally as important as your investment objectives -- your risk tolerance.
Your risk tolerance dictates how aggressive you should make your portfolio.
Everyone wants to generate the maximum gains possible, but if you can’t stomach an occasional loss of 30 percent or more, than you’ll have to tone it down a bit.
Stocks can generate huge gains over time, but they’re also susceptible to significant losses.
In the 2007-09 bear market selloff, for example, the S&P 500 index fell more than 56 percent. Many individual stocks sold off even more.
In those times of crisis, the best move is usually to buy more and ride out the cycle.
However, if you can’t bear the thought of those types of losses, you might want to adjust your portfolio now, before the next recession hits.
For stock investors, that might mean allocating a portion of your portfolio to bonds or cash.
You might also consider buying more “recession-proof” stocks, such as consumer staples, rather than high-flying, speculative stocks.
For bond investors, that might mean selling longer-term maturities in favor of shorter-term ones, since longer-term bonds are more susceptible to movements in interest rates than shorter-term bonds.
Those who don't want to worry about tweaking their portfolios can use investment options such as:
These options will diversify your portfolio according to your risk tolerance. You shouldn't have to do anything as you weather the recession -- the portfolio allocation will adjust automatically.
Positioning Your Overall Finances
The best way to survive a recession is to be in a position where a recession won’t matter much to you.
For starters, it’s always a good idea to have some cash around to pick up bargains when the stock market goes on sale.
Some in the industry refer to this as “having dry powder” so you can take your shot when the price is right.
But beyond investment planning, having the rest of your financial life in order is the best way to weather a recession.
Here’s a quick run-through of how to prepare yourself.
1) Have no debt
Debt is a killer.
If you’re struggling with making ends meet, the last thing you need is to be making payments on purchases you’ve already made.
Even worse, in a recession, interest rates often spike. If you have credit card debt, those notoriously high interest rates will only get worse, creating an even greater financial drag.
Generally, experts suggest that the only type of “good” debt is debt that generates money for you.
For example, one could argue that a home mortgage is “good” debt, in that your home will hopefully appreciate in value. Along the way, you get a tax deduction for your mortgage interest to boot.
Another example of “good” debt would be investment debt, such as a rental property or business that generates profit.
Beyond that, debt is a financial drag.
If a recession is around the corner, you’ll want to be out of debt before it hits.
2) Build an emergency fund
A solid emergency fund should be part of your overall financial plan from the start.
Even if you’re a good budgeter, surprises happen. Without an emergency fund, you might have to go into debt to pay off unexpected expenses, which is less than ideal.
Ideal Size of an Emergency Fund
| To start... | Ideal goal... | Super safe... |
|---|---|---|
| $1,000 | 3-6 months of essential expenses | 12 months of expenses |
Most experts suggest your emergency fund should be large enough to sustain you for three to six months.
If you feel a recession is lurking, you might want to bump up that reserve to a full year.
There’s nothing like the peace of mind in knowing that even if your lose your job or have unexpected emergencies, you have cash available to get you through.
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3) Remain employable
Workers are usually the first casualty of a recession.
When profits shrink and costs rise, companies hunker down and trim expenses wherever they can.
Inevitably, this leads to layoffs, whether you’re talking about the mom-and-pop store on the corner or the largest corporations in the world.
To avoid calamity, make sure that you remain employable.
What does that mean?
Remaining employable means making sure you don’t work in a job that will be the first to go when a recession hits.
You’re generally safer if you work in a capacity that provides great value to your employer and that would be hard to replace, especially with a cheaper alternative.
Often, lower-paying jobs are the first to go, along with part-time employees and new hires.
If you have an advanced degree or a special skill, that can be hard to replicate. These are the types of jobs that are more recession-proof.
So, if you find yourself in one of the “first-to-go” jobs in a recession, consider your options.
Ask your employer if there’s a path to a more entrenched position. See if there are any courses you can take or skills you can learn to make yourself more employable.
Do everything you can to make sure you are not first in line for the chopping block.
4. Trim expenses
This is sound financial advice for any occasion, not just if a recession is coming.
Most Americans suffer from a phenomenon known as “lifestyle creep.” This is the tendency for households to spend more money as they make more money.
There’s nothing inherently wrong with the idea; after all, when you earn more money, you should be able to enjoy it, right?
The problem is that it’s much harder to go back once you’ve started enjoying a new, higher-spending lifestyle.
But if a recession hits, you might not have a choice.
In a recession, you might face the prospect of reduced income. Even if your income holds up, you’ll almost certainly face higher costs, in the form of higher interest rates and higher costs on everyday items.
In this environment, it can be painful to give back some of the lifestyle you’ve already adjusted to.
Luxury trips, fancy cars, and expensive dinners out on the town might not be a reality during a recession.
An easier way to prepare for this scenario is to trim expenses while your income is still rising.
For example, let’s say you receive a $10,000 raise when times are good.
Rather than plowing that all of that extra money immediately into a new car payment, or a bigger house, or luxury goods, take half of your raise and put it into your savings.
You’ll still get to enjoy another $5,000 in income annually. But at the same time, you’ll be building your savings for a rainy day.
It’s a win-win.
5. Keep saving
If things turn bleak in the markets, sticking to your original savings plan can reap big long-term rewards.
Ideally, when times are good, you’ve already set up regular monthly investment plan.
If recession strikes, stock values typically decline.
If you continue your regular investment plan, you’ll be buying when prices are low, so that you can sell high later.
This process is known as dollar-cost averaging.
When you make regular investments of the same dollar amount, by definition you will be buying more shares when prices are low, and buying less when prices are high.
Over time, the shares you bought during a recession may prove to be very profitable.
Everyone loves a sale. When the market turns down during a recession, think of it as buying shares of great companies while they are on sale.
Conclusion
The bottom line is that no one likes going through a recession. Typically, the market sells off, the job market becomes uncertain, and costs may rise.
However, recessions are a regular part of the business cycle.
The good news is that even in the darkest recessions, the U.S. economy has found a way to get through.
Ultimately, stock market prices will recover, as will the labor markets and the economy as a whole.
With a long-term view, you can ride out these temporary and completely normal setbacks.
Since no one can predict a recession with any level of accuracy, it’s best to always be prepared.
Put yourself in a position where you can ride a recession out in the best possible way.
When it comes to your investment portfolio, try to avoid major changes. Stick to your regular investment pattern.
If you can’t sleep at night doing that, you’re probably in the wrong long-term asset allocation to begin with.
Consider talking with an investment professional to help align your portfolio with your risk tolerance and long-term investment objectives.
Above all, remember that this too shall pass!
