6 essential tips for investing in a recession

Disclaimer: The following article is not a financial recommendation or investment advice to investors for dealing with a recession.  It is an informative piece, intended to educate our audience on possible options for investing in a recession.   

Recently, we've seen mixed signals about a potential recession.  While the stock market is optimistic about the prospects for the U.S. economy and corporate earnings, the bond market is signaling gloom and doom. 

Are you wondering what you should do in the case of an eventual recession?  And what measures should you take today to protect yourself from the downside? 

If this is a concern, you came to the right place.  Investing in a recession is a highly personal issue--we polled a dozen of Finstead pros and asked them how to deal with a recession when it comes to managing your personal investments.  As you can imagine, the answers vary quite a bit, but there are some key themes we'd like to highlight. 

1.  Always have enough cash for eventual emergencies

Sarah Carlson, the founder of Fulcrum Financial Group, recommends that you recession-proof your portfolio by allocating  an appropriate emergency fund that can cover 3 to 6 months of living expenses. 

But should you be making any changes to your portfolio allocations as you go through a recession?  

One option is to do nothing if you're certain about your comfort level with investment risks.  But how will you know this indeed is the case?  

2.  Now is the time to stress test your risk preferences

How will you react if your portfolio declines 40% and a recession lasts 3 or more years?  Will you sell a portion of your portfolio, change allocations, or do nothing?  

As a matter of fact, a recession is a good time to understand your emotional comfort to fluctuations in the market.

Bob Johnson, a finance professor at Creighton University, recommends you establish an Investment Policy Statement (IPS) and follow it, if you are working with a registered investment advisor.   An IPS is a written document that clearly sets out a client’s return objectives and risk tolerance over the client’s relevant time horizon, along with applicable constraints such as liquidity needs and tax circumstances.

If you don't work with a financial advisor, set your own investment rules, write them down, and follow them at all times.  

To win the investment game, it is not necessary to make decisions based upon changing market conditions. Investors should not concern themselves with broad market moves or a crisis-du-jour--a thoughtful, consistent strategy will help you win in the long run.  

But what should you do if you realize that you don't have the stomach for a significant (and perhaps temporary) loss of your assets?

3.  If a potential asset loss stresses you out, adjust your portfolio allocations now

Reduce your exposure to equities and increase your exposure to bonds.  Diversification can help reduce risk by providing more of a broad market exposure.

In a recession, like in any other time, investors will want to regularly rebalance their portfolios to help keep them aligned with investment goals, notes Michael Bus of PNW Financial.   Over time, investment positions can drift out of alignment with one's goals, as positions grow and recede, and the goals may change.

But for some of you who are risk-loving, and are seeking an alpha above and beyond what the market offers, a recession may be a good time to shop for bargains.  Not that this could be quite risky, and we don't generally recommend 'shooting for alpha' to people who don't study the market diligently.  This brings us to our next thought. 

4.  In a recession, certain investments perform better than the rest

Different asset classes and sectors of the market do well at different periods within the economic cycle.  If a recession is likely, the typical playbook says that interest rates will be falling as the Federal Reserve cuts rates to stimulate the economy.

Ron Rough, Director of Portfolio Management at Financial Services Advisory, notes: "Within the stock allocation, I would focus on areas such as utilities and Real Estate Investment Trusts (REITs) that tend to do well when interest rates are falling, as well as companies that tend to do well whether the economy is rising or falling. That includes Consumer Staples (think razor blades and household products) and drug companies, and even some internet or other technology companies." 

Rough's research indicates that the following investments are usually a good bet in a recession:

• High quality bonds (US government, high quality corporate)
• Interest sensitive stocks (utilities and REITs)
• Consistent earnings growers (consumer staples, and certain healthcare, communications and technology companies)
• Money market funds

In a recession, value stocks typically outperform growth stocks.  Value investments also do well in the boom period, but tend to under-perform growth strategies.  

"As an investor you never really know when the overall market will switch from bull to bear or from bear to bull," says Michael Osteen of Port Wren Capital.   "And once you know there has been a switch, it is too late to respond properly.  To prepare for a possible recession, I would recommend buying value investments." 

Whatever investments you choose at the end of the day, there is one principle you should stick to:

5.  Don’t use long-term money to solve short-term money problems 

You should be fully invested with your retirement money--these assets are critical for your financial independence. 

Dipping into your retirement pool will prevent you from reaching your life goals on time.  Plus you may have to pay a penalty for doing so.  

Although recessions can be emotionally exhausting, there are some opportunities that can appear on the horizon.    This brings us to our final thought. 

6.  Capitalize from the upside of being in a recession

"When the stock market is facing a down turn, it can potentially be a great opportunity to buy stocks at a discount", notes Sandy Yong, the author of the book The Money Master. 

Historically speaking, the stock market has always gone up.  As long as you have a long-term vision, there is no need to panic.

So here is the bottom line.  You should recession proof now: understand your emotional reactions to a potential asset loss, and make changes to your portfolio allocations as needed so you can better prepare for what might happen in the future. 

And when the thunder strikes, if you're an alpha seeker, look for opportunities to buy securities at fire-sale prices!