How to Invest During a Recession
Investing during a recession, like many other things in the investing world, depends – but our goal in this lesson is to arm you with the knowledge you need to make the best decision for you.
Most commentators and analysts agree that two consecutive quarters of decline in a country’s real gross domestic product GDP is a practical definition of recession.
Summary: How to Invest During a Recession?
Recession and it’s Causes
Before we get too deeply into the investing opportunities and strategies of How to Invest During a Recession, let us define what a recession is and what causes it:
There is no formal definition of a recession, although the IMF claims there is widespread agreement that the phrase refers to a period of fall in economic activity. Although very short periods of loss are not called recessions, most commentators and analysts use two consecutive quarters of decline in a country's real (inflation adjusted) gross domestic product as a practical definition of recession (GDP).
Nonetheless, the National Bureau of Economic Research (NBER) is the authority on determining the timing of US recessions. Thus, theoretically, we might have two negative GDP estimates but not be officially in a recession if the NBER does not believe we are. The truth is that most of economics is theory and not fact as it commonly believed.
Another point to consider is what causes a recession and whether or not we can forecast it. So if we can safely forecast it, as investors, we may be in a better position to exit equities before prices plummet. This is what many of the world’s top investors did before this recession, and in fact, some renowned investors like Warren Buffett had sold any unnecessary stocks and accumulated cash reserves before the Corona Flash Crash back in 2020.
While that would be great, predicting a recession is actually pretty tough for a novice investor who has not learned the ropes of economics. However, there are several indicators that attempt to predict recession risk.
The US Federal Reserve system provides two. One can examine the bond market yield curve. An inverted curve with long-term 10-year bond yields lower than short-term 3-month yields indicates a significant chance of a recession. Another examines traditional economic data, such as employment, personal income, and industrial output. These are lagging indicator, however, meaning that they don’t start giving the recession indication until we are already into one. Though for those who are watching closely, it means that they can get in earlier than others who take a few months to catch on.
The Financial Conditions Index is another US Federal Reserve system indicator for gauging recession risks. This includes everything from the stock market to mortgage rates and corporate bond performance. When central banks raise interest rates, these conditions inevitably tighten, slowing the economy. A reading above 0 on this chart has historically been a solid predictor of an approaching recession.
What Happens to Assets During a Recession?
Well, so we’ve discussed the widely recognised definition of a recession and its causes, but before we determine How to Invest During a Recession, let’s look at what happens to the values of various asset classes when we enter a recession.
In the past, equities have outperformed the other main asset classes during recessions. Defensive equities, such as real estate, have performed better than the most historically vulnerable sectors, such as overseas stocks. High yield corporate bonds have performed better, but have fallen in value with equities. Historically, investment-grade corporate bonds have performed the best.
Using this information, investors might potentially adjust their portfolios during an economic cycle if they fear a recession is imminent. For example, if an investor sees the economy slowing, they may want to sell some of their stocks and equity positions and invest in US government bonds, which have historically performed better in these instances.
A movement like this is called rebalancing your portfolio and is an essential step in remaining a profitable investor. Afterall, we cannot control the market, but we can control what we do in response to it.
Taking Lessons From the Past
Before we go into How to Invest During a Recession in terms of specific industries that perform better or worse, let’s go over some recession facts.
After WWII, the United States has had 11 recessions. They typically endure 10 months from peak to trough. They’ve also been shorter as central banks have become more adept at regulating the economy.
Every economic downturn and subsequent equity bear market is unique. All, though, can be frightening and motivated by a fear of the unknown. But, history demonstrates that economies, businesses, and consumers are resilient and eventually recover.
The typical “bear” market lasts 19 months and drops 38%. In comparison, the average ‘bull’ market lasts roughly four times as long, is four times larger, and is built on reduced inflation and interest rates caused by the recession.
Be fearful when others are greedy, and greedy when others are fearful.
Warren Buffett
Given this information, longer-term investors may begin to create the opinion that investing during a recession can be profitable in the future. As a reminder, the long-term yearly return on the S&P 500 is 10%. Some investors would save money to invest during these times because they regard it as an opportunity to buy at a concession. ‘Be fearful when others are greedy, and greedy when others are fearful,’ says Warren Buffet.
Yes, timing the bottom would have been tough if we had invested during the 2020 pandemic, the Great Financial Crisis of 2008, the dot com boom in 2001, and the oil shock of the 1970s, but the recovery from these disasters was far larger and longer lasting.
Investing During a Recession
When outlining How to Invest During a Recession, the question becomes, do we look at dollar/pound cost averages or do we try to time the market? It’s even possible to mix the two during periods of considerable depletion.
Other investors may continue to add to their investments in the major equity markets, such as the S&P 500, regardless of where the price is trading, but for every 10% drop, they may try to add a larger lump sum to hopefully and potentially take advantage of the recovery. Remember, history may be on our side here, and if you are long-term focused and patient, there may be a better chance that things will go in the direction you desire.
The advantage of attempting to time the market perfectly is that you can buy at the lowest prices and get the largest returns. But, as previously said, doing so is difficult. If you get it incorrect and it continues to fall, you are locked at the price at where you purchased, whereas someone who averages it can still benefit from lower pricing.
If you have the time to be more active, you can see the value of being more proactive in your investing, which we shall discuss further momentarily. Yet, if you work full-time and don’t have a lot of leisure time to devote to investing, periods of large drop may tempt you more than periods of record highs.
The Right Asset at the Right Time
How do you want to Invest During a Recession? For individuals who want to take a more proactive approach. What else would we benefit from being in the know? Well, it could be useful to know which stocks or sectors suffer the most when we enter a recession and which ones perform best when we exit one.
Certain industries outperform others at different stages of the cycle. Conventional defensives such as utilities and healthcare outperform when a bear market begins, but as the market and economy recover, technology and consumer discretionary outperform. To put it simply, if someone is involved in tech stocks such as Apple and Microsoft, it may be prudent for them to remove these from their portfolio and invest in firms that do better in a recessionary climate.
Several experts consider Walmart to be a recession-proof company since its stores sell commodities that we will always need, such as food and personal care products, at reasonable costs. Yet, if we are emerging from a recession and markets begin to recover, investors may turn to more luxury companies as individuals increase their discretionary spending.
Conclusion: How to Invest During a Recession?
As we have discussed during these articles that make up our Free Course in Investing, investment decisions will differ from person to person, depending on a variety of characteristics such as age, risk tolerance, time horizon, and financial goals.
A short-term investor may be more concerned with the current macro-environment and determining which markets would perform well in particular conditions. They could profit from current economic data and changes in market fundamentals.
If someone is seeking for the long term, they may not be concerned with short-term price swings in markets and may not be looking to timing the market as precisely as possible, but would rather remain constantly invested and allow compound interest do the talking.
When considering How to Invest During a Recession, remember to find your “why” and have faith in your method. Be varied and patient. You can do it! If you are interested in how to invest during a recession, you must also understand how inflation influences the markets.
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Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.
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