Because of the global health pandemic, government officials have instituted a global shutdown in virtually all non-essential businesses in an attempt to “flatten the curve.”
This “social distancing” may not cure the disease. However, the goal is to instead delay or spread out the number of cases over longer periods of time. By elongating the timeline in which the number of cases occur, hospitalized patients have time to recover. This frees up resources (ventilators, bed spaces, etc.) for newly infected patients.
While these drastic measurements certainly work to delay the spread of the contagion, another threat looms.
Federal Reserve bank president James Bullard projects unemployment claims to increase nearly 30% and GDP to decline nearly 50%. Because of the shutdown, many industries are on the brink of bankruptcy.
In 2020, it’s looking increasingly likely to be a year of economic recession.
Recessions aren’t the end of the world for investors
Because the United States hasn’t experienced a recession since the Great Financial Crisis of 2008 and 2009, many investors have a fear of the unknown that recessions present.
However, economic contractions are ordinary parts of the business cycle. In fact, recessions have historically occurred every 4 years. Often, they’re accompanied by Bear Markets (sustained declines of 20%+).
Think of a recession as an “exhale” before the economic bull continues its run higher.
Simply put, a recession is just two quarters in a row of negative gross domestic product (GDP) growth. We often don’t know for sure that we’re in a recession until it has already occurred.
However, there are key indicators of an economic recession
The most obvious real world sign of a possible recession is an increase in unemployment.
The Bureau of Labor Statistics (BLS) carefully compiles studies through payroll and unemployment data to assess the state of the economy. Coupled with how many people are seeking unemployment benefits, we have a pretty good idea of how the economic engine is performing.
If the economy contracts, there is less demand for goods and services. In response, companies reduce their production so that supply matches demand. If overall demand stays compressed, the company may be forced to layoff workers to maintain profitability. These newly laid-off workers now have less money to spend which reduces demand, and the cycle continues.
In sustained periods of economic recession, this process continues on a large scale.
Market reactions in a recession
In response to an impending recession, the stock market often sells off in anticipation of a slow down. After all, the profitability of many companies is diminished during downturns, so the valuation of the company must decline to meet the realities of the business environment.
Just like a sharp market decline may precede an official recession, markets often bound higher before the actual economic “bottom.”
To safeguard their capital in anticipation of a recession and market sell-off, investors and money managers often buy longer term government bonds. While interest rates may be low, investors and managers would rather preserve their money instead of risking it to the market during recessions. As demand for these longer dated bonds increases because of bond buying, the interest rate declines.
The result? An inverted yield curve. This means the interest rate on the longer dated bond (i.e. 10-year Treasury bill) is less than a shorter duration bond (i.e. the 2-year Treasury).
Ordinarily, investors would require a higher rate of return on longer duration bonds. However, if market participants believe the likelihood of recession is high, they may be willing to purchase lower yielding, long-dated bonds for security even if the interest rate is lower.
How to invest during a recession
Fine-tuning your investing strategy before a recession is the key.
For long-term, buy-and-hold investors, a recession is nothing to fear. Sure, you may lose 20%-30%+ of your invested capital. However, recessions also provide wonderful buying opportunities for those who don’t panic sell.
During recessionary periods, the equities of great companies get indiscriminately sold by funds that hold their stock. Some of these funds and managers are forced to sell due to margin calls. Others need to raise cash to meet redemption demands.
For market-leading companies, the long-term value isn’t completely squashed.
Sure, their could be more pain ahead in the near-term. However, the economy and market eventually recovers.
Having a long-term mindset that goes beyond the current market turmoil is key to successful investing.
Think to yourself, “Where will the market or stock/fund be in 10+ years?”
Thinking beyond the current crisis can help you maintain perspective.
Fear causes panic selling. While company earnings may be suppressed during a downturn, the stocks of companies get overly punished by fearful investors.
More than likely, the stock of the best companies you want to own only gets cheaper. During downturns, the best companies can often gain market share as their weaker competitors are forced out of business.
Once the economy recovers, the best run companies can come out of a recession even stronger.
Knowing these truths and setting firm rules during calmer times can keep you from panic-selling with the crowd.
Instead, you can confidently buy stocks and funds at a huge discount. When the cycle inevitably recovers and the American economy begins growing again, these equities will also appreciate in value.
Preparation BEFORE a downturn will help you plan psychologically. After all, it’s hard to buy when everyone else is selling. Pundits on the news may make it seem like the world is ending to gain viewership.
However, our economy is resilient and has always bounced back. This current crisis will eventually pass.
To confidently invest during a recession, you must understand your purpose for investing, identify measurable goals, and implement processes to succeed.
1. Identify your purpose
We all have different underlying reasons for investing.
Most of us are investing for our retirement. Like Rich Dad Poor Dad teaches, we want to leverage our active income to create passive income. Eventually, our portfolio can sustain or enhance our lifestyle. Some of us want to invest to be financially independent or retire early (FIRE).
For those with kids, saving for college may be another goal. Others may be investing for their next home or car. For those of us with qualified High-Deductible Health Plans, we love investing in the triple tax-advantaged Health Savings Account (HSA) for our future medical needs.
Ultimately, most of us want to grow our money over time to increase our net worth and enhance our family’s lifestyle.
Even during an economic downturn, your purpose probably won’t change much. However, understanding your “why” for investing can keep you investing during down markets.
2. Set SMART investing goals
Setting goals is a global tradition each new year. However, studies show our New Year’s resolutions rarely last past February.
One way to ensure you reach your goals is to set SMART Goals.
SMART stands for Specific, Measurable, Achievable, Realistic, and Timely.
When you set investing goals, make sure you check-off each one of these criteria for optimal success.
Let’s look at an example of a SMART Goal
Perhaps, your goal is “saving for retirement.” Certainly, this is an admirable and worthwhile financial choice to make.
However, there’s really no way to hold yourself accountable for accomplishing the goal. In the end, this could mean you continue putting off opening that 401(k) or IRA and saving for retirement until next year – and then the next year.
However, instead say, “I want to save 15% of my gross pay in my 401(k) for retirement by December 31.”
This statement is much more actionable. It’s specifically outlines what you want to do. You can measure whether or not you achieved your goal. Realistically, saving 15% is achievable and sustainable. Finally, there’s a deadline or timetable for when the goal should be accomplished. At December 31, you can clearly see if you accomplished your goal.
Your goals should be irrespective of influences outside of your control
As shown in the above example, your goals are irrespective of circumstances outside of your control. This includes market performance and macroeconomics.
For those who set the goal of saving and investing 15% of their annual income, it doesn’t matter if the market is up or down. They achieved their goal.
Whether the market is up or whether the market is down, success is defined by achieving your investing goal.
Over the long run, the stock market has averaged 10%. However, in any given year, the market could be up or down. Investors who set the goal of investing a specific amount of money each year will continue investing through down cycles.
During these down markets, they continue to lower their cost basis. Lowering your cost basis in a recession means you’re buying stocks at cheaper prices. For investors who have the ability to think past today’s crisis, they will be rewarded over the long-term.
3. Implement Investing Processes
Automate. Automate. Then, automate more.
Henry Ford revolutionized the manufacturing industry thanks to his innovative assembly line. Assemblers specialized by performing the same tasks over and over in their unique workstation. This specialization allowed for massive productivity, increased efficiency, and incredible outputs.
Just like Henry Ford’s processes changed the automotive industry forever, implementing processes in your investing can change your family tree for generations to come.
Become an “Assembler” in your portfolio
One of the best ways to accomplish your investing strategy during a recession is by instituting processes and guidelines.
Implementing an investment process takes emotions out of the decision. Simply, do your job and allow others to do the work for you!
Passive investing during a recession takes the stress off you
By taking a passive investing approach with index and mutual funds, you can limit many inherent risks with investments.
Minimizing portfolio risk
By purchasing a broad-based index fund (such as an S&P 500 or Total Stock Market Index fund), you achieve instant diversification. Your dollars are automatically divided among hundreds (or thousands) of companies.
If one company goes bankrupt during a recession or economic downturn, another company is there to offset the negative performance. As total productivity eventually turns around, the index fund will track the benchmark and improve with the overall economy.
Index funds give you broad exposure to a wide variety of companies and industries that react differently.
Dollar-cost-average to eliminate market timing
For most investors, timing the market is a feeble task.
None of us have magic powers that allow us to predict the future. Even the best money managers in the world can’t predict what the market will do with any degree of certainty.
In a recession, it may be particularly tough to pick which sectors, industries, and companies will be outperformers (or even survive), let alone the bottom.
If you do manage to pick the outperformers, determining when the bottom will occur is even tougher if not impossible.
Dollar-cost-averaging is the practice of investing the same amount at specified intervals of time. For instance, you may dollar-cost-average in your 401(k) each payday. This means you’re making an automatic contribution into your account every two weeks.
Even if you don’t have access to an employer-sponsored retirement plan, you can still dollar-cost-average in your IRA or brokerage account. Most brokers allow automatic contributions.
Pay yourself first by setting up an automated investing schedule on the first day of each month. You may not be putting all of your capital in the market at the very bottom, but you will be investing into the decline, lowering your cost basis along the way.
As the market attempts to rebound, your contributions will continue purchasing fewer shares.
Automatically reinvest dividends
If you haven’t done so already, consider enrolling in a dividend reinvestment plan (DRIPs) through your broker during a recession.
For the companies that declare cash dividends each month or quarter, you have the option of storing in your dividend in cash or having your broker reinvest in the stock that paid the dividend.
During market booms, some arguments can be made to store dividends in cash. At all time highs, you may want to increase your cash position. Allowing the dividends to accumulate in cash can allow for proper portfolio diversification.
In a recession-induced sell-off, you can keep your allocation percentage consistent by using some of your cash to buy depressed equities.
Plus, enrolling in a DRIP will have your broker automatically buy shares with dividends at lower prices. In return, you’ll be lowering your cost basis.
Plus, next month or quarter, the dividends will compound and purchase even more shares if the market stays depressed.
Passive, automated investing will keep you on track during a recession
Most of us don’t realize the psychological toll of losing 30%+ of our net worth in a recession-induced downturn.
We may think we have the nerve required to invest when the market is roaring higher. After all, it’s easy to look like a genius when the economy is booming and everything is appreciating in value.
However, when the tide goes out, you can see who has been swimming naked.
Recessions expose companies that are over-leveraged or have been building a house of cards. For us investors, it also exposes weaknesses in our portfolio, investing strategy, and even mental state.
By clearly defining our investing purpose, setting SMART goals, and automating our investing strategy to achieve our goals BEFORE a recession is key to passive investing in a bear market.
Pingback: How I'm Spending my $1,200 CARES ACT Stimulus - Traceview Finance