Recession Primer, Part Six: How to Invest During a Recession

David Frost // How To Invest, Market Outlook


February 28  

This is part six of a series on recessions. This part is about how to invest during a recession. Click here for part one. Click here for part two on what recessions look like. Click here for part three on why recessions occur. Click here for part four on recession signals. Click here for part five on recent recessions.

Recessions can be tricky times for investors, and not just because of uncertainty about the future. All that uncertainty adds up to certain rotations within the investment market. When investing during a recession, it’s wise to strike a balance between capital preservation and creation. As with all parts of the business cycle, you should also diversify your holdings to seek protection from downturns in one part of your portfolio making it so you can still invest during a recession.

Safe-haven investments

Preserving capital often means rotating into safe-haven investments such as gold or bonds. Most investors prefer such investments because they are less risky than stocks and some other assets. Safe-haven investments are deemed as such because they serve as a store of value, or they increase in value during recessions and economic downturns. 

Of course, one of the reasons these so-called “safe havens” increase in value is because demand for them increases during recessions—precisely because they are considered to be safer options than other asset classes. In other words, if you get in late, you’ll be paying more for them than those who got in as the recession was just beginning.

Gold is a traditional safe haven because it provides a way to store value that isn’t affected by changes in interest rates. Gold has long retained its value even through difficult times, so it also provides a bit of insurance for your investment portfolio. Other commodities like copper and silver can also serve as stores of value during economic downturns because they offer physical value rather than just paper value.

Bonds are also considered a safer investment than many other assets, especially U.S. Treasuries. The amount of risk associated with any bond is tied to the quality of the issuer. The federal government is a safe bet, providing essentially zero risk of not being paid back, even during economic downturns. Not only do Treasuries provide a safe place to invest, but they also offer a steady stream of income in the form of yields.

The ultimate safe haven during a recession is cash, but it doesn’t offer a yield or return, and inflation has a negative impact on it. One other good thing about holding cash is that it enables you to wait until the best time to invest and then buy in cheap before prices go back up. However, keep in mind that it can be nearly impossible to time the markets accurately, and while it is wise to keep some of your assets in cash, it isn’t a good idea to cash everything out during a recession.

Defensive versus cyclical sectors

Stock investing during a recession usually focuses on defensive sectors rather than cyclical ones. For example, the consumer staples sector tends to be a stronger sector to invest in because companies in the sector sell items consumers need, whether or not they are doing well financially. Other examples of defensive sectors include utilities and healthcare. 

These areas all represent parts of the economy where spending will continue even when consumers don’t have as much money to spend as they do in the good times. Their earnings do not depend on the state of the consumer because demand for their goods or services remains constant, no matter what is happening in the economy.

On the other hand, consumer discretionary companies sell items consumers will buy less of during a recession because they don’t need them and can’t afford them. Other cyclical sectors include materials, real estate and financial services. They are considered cyclical because the companies in them depend heavily on the business cycle and the state of the average consumer. 

The earnings of cyclical companies typically follow the overall business cycle, growing during times of economic expansion, declining during a recession, and entering a recovery phase when the economy is in recovery mode. Demand for goods and services in cyclical sectors weakens during recessions because consumers don’t have as much extra money to spend. 

Finding hidden gems

Another option for investing in stocks during a recession is to target high-quality companies, which are those with strong brands, steady balance sheets and predictable cash flows. Try to avoid companies with a lot of debt because they may become unable to pay their debts back if business goes sideways during the recession. 

A great way to invest during a recession, specifically in stocks, is to look for companies whose stocks decline despite the fact that their earnings have little to do with the economic cycle. The healthcare sector isn’t entirely recession proof even though it is more defensive than other sectors. There are enough companies in the sector which are recession-proof that it may offer a good source of defensive stocks with declining prices. 

Investing in funds during a recession

It’s also important to diversify your holdings, no matter where the economy is in the business cycle, although this becomes even more important during a recession. Even though defensives are a safer bet than cyclicals, it isn’t a good idea to pour all your assets into just one or two sectors. By diversifying, you can protect your portfolio from sudden downswings in the market and still be able to invest during a recession.

Investing in funds can be an easy way to diversify, but it’s important to choose different types of funds. If you choose a variety of different kinds of funds and then continue to hold them throughout the business cycle, you protect your portfolio from changes in the cycle. When one set of funds is underperforming because of weakness in the economy, odds are that the other set of funds will be outperforming. 

For example, fixed-income funds contain bonds and other securities that offer a fixed income, which means they tend to do better during a recession. On the other hand, equity funds might struggle more during a recession, although if the fund has diversified its own portfolio well enough, they should be able to withstand economic downturns. Funds which focus entirely on large-cap stocks may also offer a bit more protection than those which focus on the Russell 2000 or other small caps. 

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost