Figuring out where to invest money during a recession is a challenge that most investors struggle with. After all, it can be hard to identify amazing buying opportunities when share prices are seemingly in free fall.
Yet, investing during a recession can be a highly lucrative opportunity when approached correctly. Let’s dive into how to do just that and what risks are involved.
What happens to investments during a recession?
Recessions don’t have a clear definition. But generally speaking, the term describes an economy after it has suffered two or more consecutive quarters of decline gross domestic product.
Apart from poor economic growth, these unpleasant macroeconomic environments are usually paired with job losses. Rising employment, in turn, leads to a slowdown in consumer spending. With less money flowing through the economy, the situation only gets worse. Businesses start reporting less impressive earnings, the number of bankruptcies starts to rise, and consequently, stock prices drop.
Needless to say, that doesn’t exactly paint the best picture for a prospective investor. But looks can be deceiving. And even those with existing portfolios can capitalise on the seemingly horrendous situation to maximise long-term wealth generation.
Is it safe to invest during a recession?
Watching a portfolio drop potentially by double-digits isn’t fun. But as unintuitive as it sounds, closing positions to try and mitigate losses often achieves the exact opposite of what was intended. Selling stocks at low prices locks in recession-related losses. And it goes entirely against what any financial advisor would tell you: “buy low, sell high”.
Instead of viewing stock positions as being in the red, it’s better to imagine walking down the aisles of a discount store. All the high-quality businesses in portfolios worldwide are on sale. And buying shares when they’re cheap is how legendary investors like Warren Buffett became multi-billionaires.
However, it’s critical to stress that investing during a recession is far from risk-free. No one knows when crashing stock prices will bottom out. It’s entirely possible to watch a seemingly cheap stock continue to fall after buying more. And for those without a strong stomach for market volatility, the continued downward trajectory might be enough to hit the sell button, even when an investor knows it’s a bad idea.
What you need to invest during a recession
Investing during a recession has a few essential requirements:
A cash buffer
Investors should only invest money they don’t need to meet living expenses. And since recessions often lead to job losses, this rule is especially important. By having enough cash in the bank to meet financial obligations for at least the next six months, the risk of being forced to sell shares at a bad price can be mitigated.
A long-term mindset
Stock prices may continue to fall even after investing at what seemed like a bargain valuation. By investing for the long-term, investments have the chance to come out ahead, allowing those bargains to deliver on expectations.
The fear of loss is an investor’s worst enemy. Incessantly checking the level of an investment portfolio during a market downturn is a one-way ticket to making rash decisions for most investors. And that almost always results in locking in recession-related losses that destroy wealth rather than create it.
The individuals who can control their urges and remain focused on the long-term potential rather than short-term volatility will make it out on top.
Where to invest your money during a recession
Investing in index funds and mutual funds is a popular strategy that most investors tend to deploy. And for these passive investors, the question of where to invest during a recession is easy to answer — just buy more shares in a low-cost fund.
But for those seeking to beat the market by picking individual stocks, the situation requires more thought.
The best long-term investment strategy for any economic environment is to buy high-quality businesses and hold onto them for the long term. When times are good, diversifying into more speculative growth stocks can be a rewarding experience. But during a bear market, this type of activity can lead to trouble.
A recession means a slowdown in growth that will impact almost every business in the economy. That means raising capital through equity is often no longer viable, and debt becomes far more restrictive. So regardless of how amazing a business might become in the future, this potential is ultimately meaningless if it can’t keep the lights on today.
Having plenty of liquidity is critical for any business wanting to survive a downturn in the financial markets. Just take a look at the stock market crash in 2020 after Covid-19 rampaged across the planet. The liquidity of most travel stocks was fairly poor before the crisis started, resulting in a surge in dependence on expensive debt, which now many can barely keep up with as interest rates rise.
Identifying the companies with lots of cash & equivalents on their balance sheet helps avoid this situation. But it also means a firm can capitalise on opportunities that its competitors are too financially weak to act upon.
That’s why it shouldn’t be surprising that 2021 saw a record $5.16trn in mergers and acquisitions — the highest in over 15 years.
Sectors that typically perform well during a recession
While an economic downturn is bad news, not every industry is exposed to the same degree of impact. Even when consumer spending is dropping, there are certain things we simply cannot live without. For example, consumer staples like food and water, as well as transport, and healthcare, all tend to outperform the various stock market indexes during a recession.
This list of ‘recession-proof stocks’ is far from exhaustive. Utilities are another sector that tends to see solid performance. After all, people need electricity and heating. The same goes for personal storage services. People that need extra space to put their stuff aren’t likely to cancel their contracts. And demand for storage facilities may even increase as companies look to downsize operations.
However, there is a caveat to consider. While these defensive stocks may outperform during a recession, the same can’t be said when the stock market and economy recover.
What not to invest in during a recession
The volatility created by recessions leads many to believe that adopting day-trading strategies is a key way to turn a portfolio around.
In fact, most who try often end up digging a bigger hole than when they started, which is even harder to escape.
Investing during a recession requires an even greater focus on buying high-quality businesses for the long term. Speculating on previously high-flying penny stocks that have taken an enormous beating is most likely a terrible idea.
In most cases, shares that have dropped by 80% or even 90% are imploding for a good reason. It’s critical to understand why a stock price is having a meltdown before investing any additional capital. Remember, during a recession, the rates of bankruptcies skyrocket. And it’s entirely possible, especially for smaller enterprises, to watch their share price plummet to zero.
Three points to remember when investing during a recession
Three critical points to keep in mind when navigating the stock market during a recession:
1. Don’t turn to day trading
There are many successful day traders worldwide. And with commission-free trading platforms gamifying the process, it can seem like an exciting way to become rich.
However, 95% of individuals (including professionals) that try end up destroying wealth rather than creating it. Simply put, day trading is not a prudent investment strategy.
2. Understand why prices are dropping
Buying whichever stocks have fallen the most is a recipe for disaster if an investor doesn’t know why they fell in the first place. Similarly, selling shares that have fallen the most without knowing why is an equally bad idea.
3. Don’t try to time the bottom
Trying to time the market is a losing battle. It’s easy to say, “I should have bought shares on this day”, in retrospect. But when in the middle of a recession, no one knows when we’ll hit the bottom.
That’s why deploying a strategy of pound cost averaging is a sensible move. Instead of investing all your money in one go, you can break it up into chunks and spread buying activity across several weeks or even months. That way, if prices continue to fall, you can still capitalise on it and bring your average cost per share down.