What’s the best investment strategy during a recession? Image credit: AdobeStock
To start with, understanding the concept of recession will help you plan for this period. A recession is a period of momentary decline in an economy that signals the reduction of industrial and economic activities in a region. The recession can be moderate or a deep recession can turn into a depression.
It is important to note that recession can be caused by different factors including high inflation. As a result of this, the central banks globally are increasing interest rates to slow down demand & control high inflation, and many experts have suggested that there is high risk of recession.
Proper preparation during a recession is among the important strategies to put in place during this critical period. Here are some important things you should consider.
Don’t put all your eggs in one basket. Diversification has been in use by many large firms and it has proven effective. In simple terms, diversification is the act of advancing into different varieties of financial entities, areas, industries, asset classes and sectors of the economy.
The major objective of diversification is gaining financial security. That is, the possibility of all the investments & asset classes resulting in a loss at the same time are low. Among many others, Exchange Traded Funds (ETFs) and Mutual Funds can help aid your diversification process.
Firstly, an ETF is a fund that uses money from its investors to invest in a basket of securities. This basket would contain a variety of asset classes such as Equity, Fixed income, commodities etc. By doing this everyone who invests in the ETF is diversified and exposed to different asset classes. ETFs trade on the exchanges daily just like normal stocks do and their prices fluctuate according to demand and supply.
Secondly, Mutual funds invest a huge amount of money gathered from investors in securities like financial assets, stocks, bonds, etc., however mutual funds do not trade on the stock exchange.
Both ETFs and Mutual funds grant you exposure and diversification thus minimizing the risk of you losing all your investments when stock prices decline during a recession.
A market is said to be shorted when an investor sells out a borrowed security in the open market. The borrowed asset is then repurchased at a lower price at a later time and returned to the lender. The investor makes money based on the level of reduction in the security’s price.
To short the markets, you can consider implementing an inverse ETF or Contract for Difference (CFD).
Firstly, an inverse ETF gives room for making money while there is a decline in the market. It doesn’t necessarily involve selling the underlying index short. It is also known as Short ETF. There are various ETFs that allow you to short the FTSE100 Index.
Secondly, a CFD is an agreement between a buyer and a seller based on price differences in entry and exit of the market. An example of this is when a buyer speculates on the price variation of gold presently and in the future, rather than buying the asset.
Unlike inverse ETFs, CFDs are not traded on an exchange hence the risk of counterparty default. But shorting the market using CFDs is risky especially during a recession. CFD contracts on various asset classes are offered for trading at forex brokers. As per this comparison of several forex brokers based on multiple factors, as high as 78% of retail investors lose money when trading CFDs at some of the regulated brokers. He added that the ASIC has done a great job at restricting leverage on CFDs and urged Australian investors not to seek oversea brokers who could grant them dangerously high leverage.
This is well said because CFDs are leveraged instruments where you borrow money from your broker. Using high leverage only increases this risk as some brokers from oversea jurisdictions, allow leverage as high as 1:1000. This means you can open orders 1,000 times the size of the capital you have in your account and this means you can also lose 1,000 times the capital you have invested.
When you go long your only risk is the price of the asset falling to zero but when you go short you risk the price of the asset rising to the sky. When this happens, you have to scramble to ‘cover your short’ by closing your position and this is a short squeeze scenario. Shorting is best suited for expert traders. If you are not an expert consider investing in Inverse ETFs where the fund managers do the work for you.
Gold is an important asset for individual investors, companies, and nations at large. It is a financial asset held in store by some countries which function during deficits in the balance of payment. It constitutes part of the country’s national reserves.
Since gold is not traded directly by individuals and corporate bodies, recession doesn’t have a huge effect on it. This is why gold is often considered a go-to place for investors when they struggle with investments during an economic recession as indicated by this research.
There are two primary types of gold available for investment, namely; gold ETFs and gold futures. Rather than investing in physical assets, gold ETFs allow investors to speculate on financial assets backed by gold.
In investments involving Gold ETFs, investors don’t have direct possession of the commodity. With the investment they put in, investors are granted access to owning commodities backed by gold in the stock market. Examples of some Gold ETFs available to Australian investors are:
Defensive stocks are yet another investment strategy that you can put in place during a recession. These stocks are not likely to be affected by recessions.
Most financial problems attributed to losses in investment can be traced down to natural disasters such as diseases, earthquakes, and storms, among others. Recession is another occurrence that slows down the growth and development of different sectors of the economy. However, some sectors always remain unaffected.
Investing in these unaffected sectors like healthcare will keep an investor on edge during the recession. This is why you should consider investing in a defensive stock that pays dividends. In simple terms, buy stock in these sectors or become a shareholder in any company in the industry.
If you want to minimize the risk of investment during a recession, then consider dollar cost averaging. This is a strategy that helps you reduce the price you put into an investment and alleviate the risk involved. It is termed “dollar cost averaging” since the investor has to invest an equal amount of dollars every month.
Example if you plan to invest $5,000 in shares of Company A that costs $10 per share, you could afford 500 shares on the spot. However, with the DCA strategy you could buy 50 shares every month for 10 months.
During a recession, stock prices mostly fall, so there’s a chance by the second month the shares could fall to $8, and maybe $6 in the third month and so forth.
The idea is when you use DCA, you end up buying more than 500 shares in 10 months since you take advantage of price declines.
In simple terms, a government bond is another form of debt sold by the government. The bond yields tend to increase during rising interest rates environment due to an inverse relation between bond prices & interest rates. When the Interest rates are rising, it is a good period to invest part of your investments in bonds if you are considering a defensive portfolio.
How does this work? Interest rates are reduced during recessions while the counterpart – bond prices – increases. With this in mind, if you buy bonds before the start of a recession and keep it, they will be of great use for you later during the recession period, or during the period when Central banks lower their rates again.
With the stored bond, you start to earn a fixed interest aka coupon semi-annually till the bond duration lapses. Bond durations can range from 1 year to a few years, depending on the bond you are investing in. You can also decide to resell the bond before it matures and exit the contract.
A REIT is a company that possesses, controls, and funds properties that generate income. It can potentially generate a reasonable overall return which comes with a steady dividend income. It is important to note that REITs cover a wide range of property sectors such as residential and commercial properties
REITs, especially those with exposure to residential properties, usually do well in a recession as people will always pay rent. This rent constitutes the income that’s shared as dividend to you. REITs make it possible for those who can’t afford to buy a home to benefit from house rents when they invest in REITs.
Investment is an integral part of growing your wealth. However, the chance of sustaining it gets truncated during the period of economic decline. But with the effective usage of different strategies, an investor can benefit from the declines on markets.