How to prepare your portfolio for a recession

The immediate threat of coronavirus has receded and the country has returned to some kind of normality, but there is now the very likely prospect of a widespread economic recession fuelled by war in Ukraine, supply chain issues and the cost of living crisis. This is a potentially worrying time for investors, but there are ways to prepare your portfolio to mitigate some of the worst effects of a recession – by Richard Pearson.

It’s also a good time to be thinking about how to add some extra protection to your portfolio in case another wave of coronavirus, or indeed another black swan event, were to be visited on us and cause similar market falls to those seen in March 2020.

There are a few things to consider when preparing your portfolio for a possible recession. For instance, if you are younger, then taking some of the precautions in this article will limit the growth potential of your investments and could lead to a diminished long-term outcome.
 

‘there are ways to prepare your portfolio to mitigate some of the worst effects of a recession’

For example, the markets usually value a company at what it believes it will be worth in the future based on how successful analysts think it will be, rather than what is happening right now. This means that to a certain extent when the economic climate deteriorates the best action you can take with your investments is nothing.

We saw with the markets in 2020 that, while the fall was precipitous, the immediate recovery was quick as well. This gives credence to the idea that markets ultimately go up over time despite temporary falls in value. If you sell at the bottom of the dip, it is very hard to get back to where you were before.

So for younger investors it could be best to just ride out the storm and try not to worry too much about the value of what you’ve invested in. As long as when you did your initial research on what you bought and the theory you developed for it remains largely the same, you shouldn’t become a forced seller.

But if you are closer to retirement, preserving some or all of the capital value of your portfolio is much more important. There are tips that will stand you in good stead and help protect your portfolio from the worst effects of an economic crisis.
 

1. Hold cash

Cash is seen as the ultimate safe haven for investors. In the worst of the market falls in March, the value of the US Dollar increased as investors sold out of assets and held Dollars in cash. With the Dollar informally seen as the ‘global reserve currency’ this made sense, but was generally a kneejerk reaction to losses.

Cash does not react in the same way to events and has a stable value, so it is a good idea to hold an element of cash in a portfolio if a recession is on the horizon. The downside of holding cash is that if it isn’t growing at all, it will lose value over time. But for a limited amount of cash this isn’t fatal.
 

‘holding cash can be a good way to protect yourself from selling other assets during a downturn’

Experts argue over how much is the right amount to hold, but it should really depend on your own personal circumstances. If your portfolio is designed to produce an income, then holding cash can be a good way to protect yourself from selling other assets during a downturn.

During the recent crisis many companies announced to shareholders that they wouldn’t be able to pay dividends due to cashflow issues caused by the impact of coronavirus on their businesses. While this was bad for investors, those that had some cash holdings could easily turn to it for temporary income, rather than being forced to sell the shares to access cash they needed due to a lack of dividend payments.

Likewise, holding cash can be useful once the value of shares has fallen, as it can be used to buy good stocks and funds that are under-priced because of negative sentiment, in the expectation that they will increase significantly in value once the economic trouble is over.
 

2. Buy gold

Like holding cash, having alternative assets in your portfolio is potentially a sensible way to protect against the worst falls of the market. Commodities such as gold do not correlate with stock indices like the FTSE 100 or S&P 500, instead rising and falling in value on supply and demand.

The benefit of holding gold in a portfolio is that often, but not always, the value of the precious metal moves inversely to the stock market, meaning there can actually be considerable growth potential by holding it when markets go down.

Investing in gold might not sound that easy, but actually doesn’t require you to buy bullion or gold rings from a jeweller. You can hold financial instruments in your ISA that track the price of gold. A good example of this is the ETFS Physical Gold ETC or iShares Physical Gold ETC.
 

3. Diversify

Holding cash and buying gold are both good diversifiers away from the stock market, but there are ways to diversify within the universe of stocks and bonds as well.

This can be done in a few ways. First, geographic diversification, or not putting all your eggs in one regional basket. When economic recessions occur, they affect different areas of the world differently. Although the coronavirus crisis has been a global one, in many instances a recession in one part of the world may not greatly affect another region.

For instance, the 2008 financial crisis affected Western economies much more than Asian ones. Investors heavily exposed to the UK, Europe and the US would have had a worse time than those who also had Asian holdings.
 

‘sectors such as finance, tech and other parts of the economy that can operate remotely, have fared better’

Similarly, diversifying across different sectors can be good. When recessions come they can come in different forms, and some sectors of an economy can be worse affected than others. During coronavirus, it is clear the worst off have been hospitality and travel. But sectors such as finance, tech and other parts of the economy that can operate remotely, have fared better.

Buying funds that have different objectives can also be a good diversifier. For instance, funds that target pure growth will be hit worse during a recession than funds that target ‘value’ stocks.

Value stocks are companies that trundle along and don’t offer the heady exponential growth of companies that are new and innovative. But when a recession hits, value stocks often take off as investors turn to dependable firms that will largely be unaffected by economic trouble.
 

4. Don’t try to time the market

Finally, don’t try to time the market to score a big win. If you sell too early you can miss out on growth, and if you wait too long for the ‘bottom’ of a crisis, it can be too late.

Similarly, if a recession comes and the market begins dipping, selling out of your assets can be ruinous, as selling at the wrong time will crystallise your losses and leave you permanently worse off.

Remember, stock markets tend to price for the future, not today. Once you’re in the middle of a recession and there are unpleasant economic figures being reported on the news, it is likely that share prices are already factoring this information in.

Instead, investing should be thought of as a long-term strategy that rides through the ups and downs of markets, using elements of the above to create a balanced portfolio that can weather any economic challenges down the road.