When a recession is on the horizon, people will often make investing mistakes. In this Smart Money Club Recession Investing lesson, we will discuss some of the mistakes investors make so that you can take your investing to the Power of X by avoiding them.
Recessions are notoriously difficult to forecast even when the signs are readily apparent. This does not mean there is nothing you can do. The stock market tends to react before the economy by a few months so you can be proactive. Toward the end of an economic cycle, portfolios should be reevaluated to ensure they are balanced for increased volatility.
Don’t drastically reduce stocks and increase bonds
Some investors who are worried about a recession will sell stocks to purchase bonds. The problem is that the timing is so difficult to predict. Some of the best equity returns will occur at the last stages of an economic cycle and right after the bottom. Being wrong on either of these points can result in underperformance of your long-term results. Maintain a balance that you are comfortable with but use any new funds to upgrade the quality.
Don’t invest only in value stocks
Many investors will turn to value stocks that pay dividends for their recession investing. This strategy can give a false sense of security. Value investing does not always reduce volatility and can be just as risky as the broad market. Normally to reduce volatility, you will want to reduce the standard deviation and the average drawdown. However, when we look at the Russell 1000 Value Index (the standard large-cap value index), or the Morningstar Large Value category, neither of these numbers decreases.
Holding a mix of dividend-paying stocks rather than the full value index is the better choice.
Many Value stocks don’t pay dividends, and therefore their risk is just as high as other stocks. Dividend stocks, however, have held up better in volatile times. So you may benefit from more dividend exposure if you invest before a recession. About 1/5th of the stocks in the Russell 1000 Value index pay a dividend of less than 0.1%, so be careful what you choose.
Don’t Invest in Low-Quality Companies
Just because a company is considered a value company does not make it a good choice. 40% of the Russell 1000 Value index were rated BBB or lower; this includes high dividend yield companies too. While a company may seem solid on the surface, it does not mean it can pay its debts and would lose its investment grade. A downgrade or missed payment can cause the price to crash. Before a recession, if you are going to do any reallocation or purchase a new set of stocks, you want to look for higher-quality companies that are more likely to continue paying a dividend. Conduct a bit more rigorous screening and confirm that a value choice is a solid dividend-paying investment. Your total portfolio should have:
- A high percentage of dividend-paying stocks
- Companies with ratings greater than BBB
- Low “risk” metrics (average drawdown, downside capture ratio, and standard deviation)
Don’t just look for high yield bonds when rates are low
Fixed income investments (bonds) can provide stability and protect your capital in volatile times but don’t assume your portfolio is safe if you are heavy in bonds. If you are just looking for a higher yield, you may be adding risk. Bond funds with higher yield exposure will more closely correlate to equities. These will not help your portfolio’s volatility.
Don’t just invest in short duration bonds
Investors will often turn to short-duration bonds to lower their interest rate risk when a recession becomes more apparent. However, short, duration bonds are beneficial when rates are rising, and when a recession is apparent, then the fed will stop raising rates and will usually begin cutting rates to account for the recession and spark an economic comeback.
You want to find fixed-income assets that have a low or negative correlation with equities. This will add stability to your portfolio if equities fall.
Don’t forget that investing is a marathon
Recessions are painful for most investors, but if you are well prepared and you maintain a long-term investment horizon, you should be more comfortable when the economy declines. You’ll be in a position to take advantage of the gains that are sure to follow. In the past 70 years, the U.S. has been in recession less than 15% of the time, and the average recession lasts for less than a year. Staying the course with a well-balanced portfolio that is consistently added to monthly/weekly will ensure that you need not worry about timing the markets. You will benefit from the overall direction of that market that consistently rises.
Did you miss Part 2 of this series? If so, click here to get caught up.
