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With the Federal Reserve raising interest rates to slow the economy and bring down inflation, some analysts think a recession is imminent. While investors are hopeful that the central bank can fight inflation without pushing the U.S. economy into a recession, what’s the best way to invest when the next recession does end up hitting the economy?
Best investments during a recession
The best investments during a recession may not be what you expect. Many investors make the mistake of becoming more conservative, when the best long-term course of action is to become more aggressive, ramping up exposure to assets that may offer potentially higher returns.
The rationale is simple: After stocks have fallen, investors are paying a lower price for the future growth of those businesses. It’s the classic “buy low, sell high” that everyone knows but that relatively few can practice because fear so often gets in our way during a market downturn.
“Once we know we are in an economic recession, the equity investment markets are probably closer to the bottom than they are to the top in valuations – and many times those markets are already well on their way in a rebound,” says M. Tyler Ozanne, CFP, president at Ozanne Financial Services in Dallas.
“In other words, once we know we are in a recession, it is too late to flee to safety – you should have done that already,” he says.
Instead, a recession is a time to prepare for the ensuing rebound in markets. Of course, a recession is not just a downturn in the market, it’s also a slowing economy that could throw you out of work and cause other financial distress. How do you balance these potential outcomes?
Here are four investments to consider making during a recession and three that are likely best to avoid.
4 investments to consider if a recession happens
When markets fall, the first response for many investors is to bail out in order to stop the pain of losing money. By discounting stocks in these moments, the market is actually increasing the future returns for investors who buy in. Great companies are well positioned to continue to thrive in 10 and 20 years, so a decline in asset prices means your potential future returns are even bigger.
So a recession – when prices are usually lower – is exactly the time to score higher returns. The investments below offer the potential for higher returns over time if made during a recession.
A stock fund, either an ETF or a mutual fund, is a great way to invest during a recession. A fund tends to be less volatile than a portfolio of a few stocks, and investors are wagering less on any single stock than they are on the economy’s return and a rise in market sentiment. And a stock fund offers the potential for high long-term returns if you can stomach the short-term volatility.
Well-diversified funds are a good option for investors who don’t want the hassle and risks of investing in individual stocks. One sound choice is an index fund based on the Standard & Poor’s 500, a well-balanced index that includes hundreds of America’s best companies and has returned about 10 percent over time. Rather than try to pick the winners, you own a piece of the market as a whole.
“Investors with a well-balanced portfolio need to remind themselves that the market has always come back” from downturns, says Brooke V. May, CFP, managing partner at Evans May Wealth in the Indianapolis area.
If you want a portfolio that may be somewhat less volatile, you might want to add some dividend stocks. High-quality dividend stocks tend to fluctuate less than other kinds of stocks (growth stocks, for example), meaning your portfolio will bounce around less. Plus, they can offer a cash dividend that ensures you’re getting some income while you’re waiting for the market to turn.
Don’t feel experienced enough to pick your own dividend stocks? Buy a dividend stock fund and enjoy the reduced risk that comes with diversification and still enjoy a solid dividend yield. Plus, if you buy while stock prices are lower, you’ll enjoy a higher total yield.
Real estate can be an attractive investment during a recession for a few reasons. First, you may be able to buy at a cheaper price than during a strong economy. Then when the economy picks up and consumers are more flush with cash, the value of your real estate may rise.
Second, you may be able to get a much better mortgage rate during a recession, when rates are likely to be much lower than otherwise. You can lock in an attractive mortgage payment for potentially decades, so even if rates rise later, you still have that below-market mortgage rate.
Many investors did exactly this in the last few years, scoring a 30-year mortgage below 3 percent. As inflation rises now and in future years, they’re paying back the mortgage with cheaper dollars, making real estate an attractive inflation hedge.
High-yield savings account
Cash? Yes, cash can be a good investment in the short term, since many recessions often don’t last too long. Cash gives you a lot of options. You can spend it if you need to, for example, if you lose your job during a recession, and it allows you to make an opportunistic investment if the stock market suddenly sells off or you find the perfect house later on.
But there is a downside to holding too much cash. Inflation can eat away at your money, and you likely won’t earn enough interest to overcome it. So, stick your cash in a high-yield online savings account and keep it for strategic purposes.
3 investments to avoid if the market is stung by a recession
If a recession hits, it’s important to focus on making the next right investment decision. And because the market is forward-looking, prices will have probably declined some before it’s clear that the economy is even in a recession. So investments that feel safe – because their price has held up or even risen – may not be especially attractive picks going forward.
Bonds tend to be safer than stocks overall, but it’s important to remember that there are good times and bad times to buy bonds, and those times are centered around when prevailing interest rates are changing. That’s because a rise in interest rates pushes bond prices lower, while a decline in interest rates pushes bond prices higher. Bonds with long-term maturities will feel the effects of changing interest rates more than short-term bonds will.
As investors start to anticipate a recession, they may flee to the relative safety of bonds. Typically, they’re expecting the Federal Reserve to lower interest rates, helping to keep bond prices up. So going into a recession may be an attractive time to purchase bonds if rates haven’t yet fallen.
On the other hand, one of the worst times to buy bonds is when interest rates are poised to rise in the near future. And that situation occurs in a recession and afterward. Investors may feel safe with bonds, especially compared to the volatility in stocks, but as the economy returns to growth, prevailing interest rates will tend to climb and bond prices will fall.
Highly indebted companies
May warns, “Companies with high debt loads that are sensitive to higher interest rates should be avoided.”
The stocks of highly indebted companies usually fall significantly before and during a recession. Investors anticipate the risk presented by the debt on a company’s balance sheet, and mark down the stock price to reflect this risk. If the company suffers a decline in sales, which is typical during a recession, it may not be able to pay the interest on its debt and may have to default.
So recessions can be very hard on indebted companies. But, as Ozanne acknowledges, if the company can survive, it may offer an attractive return. That is, the market may be pricing the company for death and when it doesn’t arrive, the stock can rise high quickly. Still, it’s quite possible that the company does not survive, leaving the remaining investors holding the bag.
High-risk assets such as options
Other high-risk assets such as options are not suitable for recessions. Options are a bet that a stock price will finish above or below a certain price by a certain time. They’re a high-risk, high-reward strategy, but the uncertainty surrounding a recession makes them even riskier.
Not only do you have to correctly predict, or guess, what will happen to a stock price in the future with options, you have to foretell when it will happen, too. And if you’re wrong, you could lose your whole investment or be forced to put up more money than you have.
Keep your emotions in check
Experts routinely point to the importance of keeping your emotions in check during periods of volatility, as often happen during recessions. Making decisions from a place of emotion can derail even the best financial plan, and here’s how experts recommend you deal with it:
- Stick with your long-term plan. “Have a long-term investment strategy or plan and stick with it no matter what the economy is doing,” says Ozanne. He points to the value of having a diversified portfolio, which can help investors weather the market’s turmoil.
- Have an emergency fund. An emergency fund can be especially helpful during the economic uncertainty of a recession. Not only can it help tide you over, but it can also help you stay invested, giving your investments time to rise again. You don’t want to have to touch your investments in the middle of a recession just to pay your bills.
- Stop watching the market. “If the volatility leaves you up at night, avoid watching values on a daily basis,” says May.
- There are more good years than bad. “Historically, there are way more positive years in the investment markets than there are negative years,” says Ozanne. “In a recession, and corresponding negative market environment, it is good to remember that better investment days are probably ahead.”
- Seek out a smart advisor. “Having an unbiased party speak reason, logic, and strategy in an emotionally charged period of time can save investors from making mistakes that could dramatically affect the long-term impact on their investment outcomes,” says Ozanne.
Investing during a recession can be a fraught experience because the market can be highly volatile and you’ll likely try to avoid short-term losses. But in the process, you may end up hurting your long-term returns. So it’s important to stay focused on your long-term plan and the better days ahead once the market turns back around. Work to keep your emotions from driving your decision-making in whatever way works best for you.