As long as there has been a stock market, there have been fears about a dramatic market sell-off. These fears came true when the coronavirus pandemic sparked a major crash in mid-March, leaving investors unsure of how quickly the market would recover. However, many stocks have bounced back to the prices they were at before the crash, although certain industries remain vulnerable.
What can you do to help protect — and even grow — your money during the next downturn? Here’s a look at some general principles you should consider before the next sell-off, along with suggestions for investments that might fare better than the market as a whole.
Last updated: Oct. 2, 2020
Review Your Asset Allocation
When you initially set up your portfolio, you likely chose a general investment objective such as growth or income, with assets chosen on the basis of this objective. Many financial advisors suggest that you review your asset allocation at least once a year because life situations and financial goals tend to change. Perhaps you started (or lost) a job, got married (or divorced), had a baby or moved to a new city. In each of these cases, you might have to tweak your asset allocation to fit your new situation.
If you fear an upcoming market downturn, it might be time to revisit your asset allocation yet again — even before your regular review. The major stock indexes have risen by double digits thus far in 2019, so it’s possible that your allocation may be out of whack with your original intentions.
Revisit Your Risk Tolerance
In addition to setting investment goals, you probably underwent a risk assessment when you built your portfolio, particularly if you were working with a financial advisor. Before the next downturn hits, you might want to revisit that risk tolerance.
Most investors say they are comfortable with high levels of risk when the markets consistently go up, but during a market drawdown, a high-risk portfolio can get leveled. If you’re a long-term investor with sufficient capital and experience handling sharp market sell-offs, perhaps you can stick with a high-risk portfolio. If not, take an honest assessment of how you would fare emotionally if your portfolio dropped by 10%, 20% or even more. As the saying goes, if you can’t handle the heat, get out of the kitchen — and adjust the risk level of your investments.
Consider Diversifying Your Portfolio
If you’ve had an entirely U.S. stock-based portfolio over the past few years, kudos to you. At this point, you’re no doubt sitting on double-digit gains. However, nothing goes up in a straight line forever. When the day of reckoning comes, it pays to have a broadly diversified portfolio. The point of diversification is to reduce risk, as some of your investments will be going up in value while others will be declining.
If you set up your portfolio a long time ago, it’s possible that new investment opportunities are now available that can help diversify your account. Or, you could revisit tried-and-true diversification options that you either weren’t aware of or were uninterested in before, such as gold, international stocks and commodities. By spreading out your risk among noncorrelated assets, your portfolio will likely fare better during the next downturn.
Cut Your Costs
Investment management fees matter more than ever when markets aren’t going up in a straight line. It’s easy to overlook the costs involved in investing when you’re making money hand over fist, but if you’re losing money, fees only magnify your losses. Before this occurs — at any time — it’s a good idea to eliminate all unnecessary fees and to minimize those that are necessary.
The good news is, investment fees continue to drop. Fidelity has recently unveiled zero-fee ETFs, and other major online brokers — including E-Trade, Charles Schwab and TD Ameritrade — have cut their commissions to zero on most equity and ETF trades. Between these options and low-cost index funds and ETFs, there are plenty of ways to trim your investment fees.
Set Up Automatic Rebalancing
During rapid market movements — either up or down — your portfolio is likely to get out of alignment in a hurry. If you only rebalance your portfolio once a year, you might miss out on opportunities to reinvest the underperforming assets of your portfolio and take profits in the outperforming ones. Automatic rebalancing not only ensures that your portfolio is rebalanced when it needs to be — it also takes the emotion out of the process, so you don’t have to wonder if you’re making the right decision or not.
Find Out: 12 Toxic Investments You Should Avoid
Do Your Homework
If you anticipate a coming economic downturn and/or market sell-off, it’s a great time to do some homework and educate yourself on business cycles. Although everyone wants the good times to last forever, that’s not going to happen. The business cycle is “undefeated” in the sense that throughout the course of history, boom periods are followed by bust periods, and vice versa.
When you study up on economic cycles, pay particular attention to what it means for stocks. For example, so-called “early-cycle” stocks do well at the very beginnings of economic recoveries, when the potential for increased growth seems largest. Late-cycle stocks are ones that fare best at the crest of economic expansion when a downturn seems likely. Understanding where you are in the economic cycle — along with which stocks do best during these periods — is a good way to help prepare yourself for a downturn.
Continue Weekly or Monthly Contributions
Hopefully, you’re already making regular weekly or monthly contributions to your investments. This is one aspect of preparing for a downturn that shouldn’t change at all. The greatest gain you get out of regular investing comes during a sell-off, when you’re able to pick up additional shares at lower prices. Sticking with your original contribution plan is a great way to get through the next downturn.
In fact, you might want to consider increasing your regular contributions to ensure that you’re making additional purchases at lower prices. The best way to do so is to automate your contributions. This way, you won’t have to worry about remembering to make them. Better yet, you won’t second-guess yourself in the midst of a downturn. Investors are often rattled when share prices decline, so taking the emotion out of the equation is the best way to stick with your plan.
Increase Your Savings
Padding your emergency fund is always smart — particularly when you see a downturn on the horizon. For overall financial planning, it’s a good idea to have extra reserves if a recession hits to account for ancillary effects. Economic downturns are often accompanied by job losses, hiring freezes and pay cuts. Having a cash cushion can help you get through the tough times if they affect you directly.
In terms of investment strategies, be sure to keep your emergency savings in highly liquid, low-risk investments. Increasing your savings rate has little downside because even if a market downturn never materializes, you’ll still have extra cash to use as you see fit.
Probably the most important rule during market downturns is to not panic. As inevitable as recessions are, it’s equally inevitable that we will ultimately pull out of them. Assuming you have at least 10 years until you retire, it’s important to not panic by selling everything. Although you might miss some of the market downturn, you’ll undoubtedly find it hard to get back in at the right time.
Remember, when markets are at their absolute lowest, fear is usually at its greatest. Not only does it take uncanny prescience to know exactly when a market is at its low, but it also takes extreme fortitude to actually buy back in. A much better course of action is to follow the steps above by ensuring your portfolio is both properly diversified and in line with your investment objectives and risk tolerance. Don’t panic — this too shall pass.
What To Invest In Before a Downturn
Beyond understanding the basic strategies to get you through the next downturn, it’s important to know which types of investments might work out better than others. Some areas tend to be more defensive or otherwise hold up better during a down market. Of course, you should talk over these options with your financial advisor or do your own research to make sure any investment matches your personal objectives and risk tolerance.
Low-Cost Funds and ETFs
Trimming investment costs is an important part of reducing the potential for a loss during any downturn. Check the expense ratios of your funds and ETFs on the management company’s website to see who’s charging the heftiest fees. While this shouldn’t be your only determination regarding which funds are better than others, most investments have comparable options from competitors that might be less expensive.
Diversified Funds and ETFs
Diversification might not protect you from losses during a market sell-off, but it can certainly reduce the bumps you’ll feel along the way. The basic idea behind diversification is that by investing in noncorrelated assets, some of your investments will rise in value even as others fall. For example, Treasury bonds often rise when the stock market sells off sharply, as they are considered safe investments that risk-averse investors flock to during turmoil. Sprinkling diversified assets such as gold, Treasuries, commodities and foreign stocks into your asset mix can help make your overall portfolio less volatile.
As previously mentioned, bonds are often seen as a safe haven during times of economic uncertainty. Money that goes out of the stock market has to flow somewhere, and quite often, bonds are part of the “safety trade” that investors flock to. Bonds are essentially IOUs. Investors lend money to a company via a bond, and in exchange, the bond issuer promises to pay interest on that money and return the principal at a specified time, known as the maturity date. This promise to get invested money back is one that can’t be made in the stock market, thus bonds are often popular during market downturns.
There’s a saying that a rising tide lifts all boats, but the converse is also true. In a broad market sell-off, most shares are likely to take a hit. However, there are some types of companies that have proven to be more recession-resistant than others. During a recession, for example, cruise operators often take a hit because a luxury vacation is a discretionary expense. Many consumers hunker down and use their funds for more pressing items such as basic necessities. Companies that provide these consumer staples often fare better than the general market during a downturn.
Certificates of Deposit (CDs)
Certificates of deposit are another good place to hide during market downturns because they’re safe investments. Nearly all CDs carry FDIC insurance, which is a federal guarantee that you’ll get your money up to the legal limit. During a recession, interest rates often drift lower, so if you can lock in higher CD rates before the next downturn you might be sitting pretty.
Bear in mind that CDs are not as liquid as savings accounts, so if you need to access your money in a hurry, be sure you understand the penalties involved for early withdrawal. Some firms, such as Marcus by Goldman Sachs, offer no-penalty CDs. It’s a good idea to shop around for the CD terms that best suit your needs.
Gold and other precious metals, such as silver and platinum, can be good investments during a downturn because hard assets like these are often in demand when markets are weak. Unlike stocks and other financial assets, precious metals are physical assets that you can actually hold in your hand. This gives some investors a sense of security during times when financial assets (which exist only on paper) are being devalued. Because the supply of precious metals is limited and cannot be rapidly increased, demand during times of market uncertainty helps drive prices higher. Gold and other precious metals are also good assets for diversification if your portfolio is stock-heavy.
Dividend-paying stocks are not immune to market sell-offs, but if you want to keep a portion of your portfolio allocated to stocks, dividend payers help make the ride less bumpy. Dividend stocks are often in demand during market downturns for two primary reasons. The first is the dividend itself, which provides investors with regular income payments even if there’s a temporary dip in the market. The second is that dividend-paying stocks are typically mature companies that have the financial wherewithal to survive or even thrive during economic uncertainty. Many dividend-paying stocks are known as “defensive” stocks for this very reason.
In the broadest possible sense, stocks are divided into two major camps: growth and value. Growth stocks are the ones that make the bulk of the headlines on financial news shows because they produce flashy products and have spectacular growth rates. Tech stalwarts like Amazon, Facebook and Netflix are quintessential examples of growth stocks. While these are great stocks to own when times are good, they might take big dips during market sell-offs.
Value stocks, on the other hand, are often “boring” investments that are overlooked by the press and don’t jump around much. These are often considered to be “cheap” relative to other stocks using such metrics as book value, price-to-earnings ratio or price-to-sales ratio. Value stocks tend to pay high dividends as well. Since these types of stocks are usually considered undervalued, to begin with, they don’t sell off as strongly as high-flying stocks when the market goes down.
Utility stocks often outperform other sectors during downturns for two primary reasons. First, most utility stocks are high-dividend plays, meaning investors are well-paid to sit and hold their utilities while the rest of the market is in turmoil. Second, utility stocks tend to hold up better than more growth-oriented stocks because most people prioritize keeping the lights on and having fresh water over other expenditures when times are hard.
Healthcare is one of the sectors that typically holds up better than others during downturns because it provides an essential service. In most cases, people are going to continue filling their prescriptions and going to the doctor even if the economy is contracting and the stock market is selling off because these are vital functions for life. For example, if you lose your job and funds are tight, you’re more likely to spend money on the medicine you need than a new $100,000 car.
Treasury securities are known as bills, notes or bonds, depending on their maturity. However, they all function in a similar manner: Investors loan money to the U.S. government in exchange for the return of that principal, plus interest. During economic or market downturns, Treasuries in particular often draw massive capital flows as they are backed by the full faith and credit of the U.S. government and are considered among the safest investments in the world. These types of bonds can be a great place to ride out any uncertainty in the stock market or in the economy as a whole.
Discount retailers such as T.J. Maxx and Walmart often perform well on a relative basis when the economy enters a recession. In fact, the earnings of discount retailers might actually increase while the rest of the economy is shrinking. This is because, in times of economic uncertainty, consumers look to protect their dollars. By shopping at discount retailers, they can stretch their money further. This is especially important for those who have lost their jobs or suffered a pay cut. It’s also important for still-employed individuals trying to build up additional savings in case things get worse.
Instead of investing in stocks and worrying that you’re making the right picks, consider diversifying your risk into a low-cost index fund. Billionaire investor Warren Buffett is one of the biggest proponents of index funds for investors, stating that after he passes, he wants 90% of his estate invested in index funds. Buffett believes that passive investing via an index fund will almost always beat out actively managed funds as well as individual investors. In the words of Buffett: “The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.”
Real estate can be a relatively safe haven when markets become tumultuous. First off, real estate is a tangible asset like gold, so it becomes attractive to investors who are fleeing stocks and other financial assets. Also, real estate is not directly correlated with the stock market so it serves as a good diversification asset. Finally, if you’re investing in real estate investment trusts or actual income-producing properties, you can also generate a revenue stream that helps offset capital losses in the stock market.
Investments To Avoid
While looking for investments to own during the next downturn, don’t overlook the toxic investments that you should avoid. Generally speaking, during downturns you should stay away from so-called “risk-on” assets that investors pile into when times are good. Most types of speculative assets fall into this category, from penny stocks to companies with high valuations and no earnings.
High-yield bonds also tend to struggle during economic recessions because they’re backed by companies with troubled credit and insufficient cash flows. If revenue starts to dry up for these companies, they’ll have trouble making the interest payments on their bonds. Research shows that during recessions, the high-yield bond default rate climbs — sometimes dramatically. This is definitely an area to avoid during the next downturn.
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This article originally appeared on GOBankingRates.com: How To Grow Your Money Safely During the Next Downturn