As worries grew about the Federal Reserve and other central banks being willing to bring on a recession to control inflation, stock prices plunged on December 16, 2022.
This is the second straight week that the Standard & Poor’s 500 has lost 1.4%. It fell by 407 points, or 1.2%, on the Dow Jones industrial average to 32,796 points and by 1% on the Nasdaq composite.
Investors’ hopes for interest rate cuts next year were dashed as well when the Fed raised its forecast for how high interest rates will ultimately go.
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Inflation, while down from its highest levels in decades, remains painfully high. As a result, the Fed has kept raising interest rates to slow economic growth to maintain its aggressive attack on prices. The danger, however, is that too much braking could send an already sluggish economy into recession.
The risk was highlighted by S&P Global. According to the report, inflation slowed business activity this month. Even with the sharp drop, inflation pressures have eased.
But, if history is any indication, the future isn’t looking too bright.
According to Fed forecasts, inflation will slow next year due to rising unemployment. Despite this, the Fed’s own projections show prices still rising at an unacceptable rate by year-end 2023, with inflation at 3.5%.
Why’s that concerning?
Inflation has been running at 3.7% or higher during every recession since 1960 except the pandemic-induced downturn of 2020. It was only in 1974 that inflation was higher than 2.7% when the recession ended.
While we don’t have a crystal ball to predict the future, it wouldn’t hurt to prepare for a possible downturn. And, one area to focus on is avoiding the following investing mistakes during a recession.
Immediately selling your holdings when they begin to fall.
When the economy is in recession, the stock market becomes highly volatile. As a result, you might be tempted to cut your losses when you see all your investments tank on the trading screen. However, when investments fail, you should not unload them.
Why? Well, here are three reasons why you should hold onto your investments.
If you sell during a downturn, you could lose money.
As a result of a market downturn, stock prices decline. The prices of investments were likely higher when the market was booming, so you likely paid more for them. In other words, if you sell during a downturn, you might end up losing money on your investments.
Remember that you will never lose money unless you sell, no matter what the market does. The only way to lock in your losses is to sell when prices are lower, even if your investments decrease in value. In short, a good way to avoid losing money is to hold onto your stocks until the price recovers.
There is no way to predict the market.
If you want to maximize your returns, you should buy stocks at their lowest prices when the market bottoms out, and sell when the market peaks. The strategy is called timing the market, and while it sounds smart, executing it successfully is extremely challenging.
There is no way that anyone can accurately predict what will happen in the stock market, not even the best investors. Even a small error in timing can result in a lot of losses in the stock market.
As an example, consider the 2020 market crash during the early stages of the COVID-19 pandemic. In just a few weeks, the S&P 500 lost more than one-third of its value. By selling your investments shortly after prices started to fall, you would have not only locked in your losses but also locked in higher profits. Also, you could have missed the near-immediate recovery of the market.
By timing the market, you might buy during high prices, sell during their lowest, and rebuy during high prices. When you hold onto your investments through the rough patches, though, you’re more likely to come out on top.
A healthy company should see its price rebound.
Stock markets are volatile, but companies with strong, healthy balance sheets have a better chance of bouncing back.
It is important to understand a company’s underlying business fundamentals in order to determine its strength. Asking the following questions can help you determine this:
- In its industry, does it have a competitive advantage?
- Are its leaders capable of making good business decisions during challenging times?
- Is it financially healthy?
In the long run, your investments should rebound after periods of volatility if you invest in solid companies. In times of market turmoil, it’s best to hold onto your investments and ride out the storm.
Strictly limiting investing amid volatility.
While some investors sell when the market dips, others don’t invest at all. In fact, according to a recent survey from Allianz Life, 65% of investors keep “more money than they should” out of the stock market.
“We’re more fixated on what we could potentially lose on paper than what opportunities pass us by that we never capitalize upon,” said Josh Reidinger, CEO of Waverly Advisors in Birmingham, Alabama, which ranked No. 59 on the FA 100 list.
If you stay away from the stock market, you might miss out on some of the best returns. As a matter of fact, over the past 20 years, the top 10 performing days occurred after big stock market declines in 2008 and 2020, during the beginning of the Covid-19 pandemic, according to Morgan Asset Management.
“History does not repeat itself,” Reidinger said. “But it’s a pretty good indicator of where we are going.”
Buying stocks at their lowest points
Stocks might be at their absolute lowest when you’re investing during a period of economic instability. Again, it’s possible to miss out on some profitable opportunities if you try to time the market that way.
In a recession, it’s best to invest consistently at regular intervals. The only thing that matters is if that stock goes up in value eventually, not if you buy it at its lowest point.
A recession can present a number of challenges when it comes to investing. However, knowing what mistakes to avoid can save you from having to live with regrets in the future.
Not understanding what you are investing in.
During recessions, Pamela Capalad, a financial planner at Brunch & Budget, says investors are tempted to invest in new, trendy investments. “Avoid anything that you didn’t understand before the recession,” she says.
For instance, if you are unfamiliar with cryptocurrency and desperate to invest in it, now might be a bad time. Capalad says, “Ultimately, it goes back to: Do you understand what you’re investing in? Do you understand why you’re investing in crypto? Do you understand how crypto works?”
“Crypto was one of the first things to take a dive when there was any hint of recession because crypto is currently all speculation,” she adds. “It’s really easy to ride a trend, especially when it’s going up.”
Investing without diversification.
Putting all your eggs in one basket isn’t a good idea. In general, investing in only a handful of stocks can be risky. The risk is even higher during a recession. However, by diversifying your capital across several assets, you’ll be able to mitigate losses if one or a few of your bets don’t work.
In a recession, exchange-traded funds (ETFs) give you exposure to a diverse group of high-quality stocks through index-tracking ETFs, helping you avoid these mistakes.
There are 2 basic types of indexes:
- A market index such as the S&P 500 is a measure of the overall market.
- An index which tracks a much more targeted subset of the overall market, such as small-cap growth stocks or large-cap value stocks. A bond index, a commodity index, and a currency index are also available.
ETFs based on indexes seek to replicate the return of the market or subset of the market they aim to replicate, less their fees. The ETF market price will differ from the fund’s net asset value, so index ETFs do not track the underlying index perfectly.
Generally, indexes based on subsets of the market compete with broader indexes based on the entire market. A small-cap index, for example, is typically compared to a broader index on the entire market by investors.
What are the best ETFs to buy for a recession? Some suggestions include:
- Schwab U.S. Dividend Equity ETF (SCHD)
- SPDR Bloomberg 1-3 Month T-Bill ETF (BIL)
- iShares 0-3 Month Treasury Bond (SGOV)
- Vanguard Consumer Staples ETF (VDC)
- Vanguard Utilities Index Fund ETF (VPU)
- Health Care Select Sector SPDR Fund (XLV)
- Vanguard S&P 500 ETF (VOO)
Checking your portfolio 24/7.
Making investment decisions based on the market’s movements and constantly fretting over your portfolio’s value during a downturn is unlikely to be profitable. Continually checking indicates worry, which could lead to emotional decisions. You should check your portfolio once a week if you can. Occasionally, big down days follow big up days.
In addition, if you participate in a workplace retirement plan like a 401(k), you’re likely adopting the practice of dollar-cost averaging. In this method, investments (typically mutual funds) are consistently purchased over time. With this strategy, you buy fewer shares when prices are high and more shares when prices are low.
You listen to the “experts.”
There’s no way Mad Money, Squawk Box, and Closing Bell along with their panel of supposedly “expert” money managers are going to predict when this recession will end.
No offense. But, it’s all for entertainment.
You may think that I’m being too harsh here. However, lead author Nicola Gennaioli examined stock prices, dividends, and data over the past 35 years to compare them with recommendations made by market experts.
In his study, his team found that investing in the 10 percent of stocks most recommended by experts yielded, on average, a three percent return. In contrast, investors who invested in the ten percent of stocks least recommended by experts earned 15 percent returns on average!
Not safeguarding your retirement.
“Building an investment plan is like formulating a diet plan – totally dependent on your goal,” writes Sanjay Sehgal in a previous Due article. “When you visit your dietician for instance, one of the first questions asked is about your goal – Do you want to lose weight, build muscle, or you wish to celebrate food?”
“But moderation, as any good dietician will tell you is the key; it’s only when everything you need is in your plate, in the right quantities, that you can achieve your goal, as well as enjoy each bite and every taste,” he adds. “A dietician’s plan begins from this understanding.
“Investments also need planning, and this planning should be based upon your risk-taking ability and your life goals.”
Consequently, we should plan our investments based on a post-pandemic financial horizon that will differ from anything we know. This now involves recession-proofing your retirement investments by following these steps:
- Take care of your health. Occasionally, there are pandemics, recessions, depressions, or high inflation rates. As a result, during a crisis, you would have a better chance of thinking clearly, taking action, and even protecting yourself against other risks.
- Have an emergency fund. An emergency fund should be equal to 6 months’ worth of income. In the event that you lose your job and unemployment is high, that is not going to save your life. But you will have some options and options for adjusting.
- Live within your means. Adapt your living expenses to match your retirement income. By living within your means during the good times, you will be less likely to go into debt when gas prices go up and more able to adjust spending in other areas.
- Stay in the market. There is always a risk associated with investing in the stock market. In exchange, you typically get higher returns over time than you would from savings accounts, fixed deposits, etc. Occasionally, the market dips, and your portfolio may suffer, but it will pass.
- Invest for the long term. What if your investments drop 15% as a result of a drop in the market? You won’t lose anything if you don’t sell. You will have plenty of opportunities to sell high in the long run, since the market is cyclical. Buying during a down market may end up paying off later on.
- Diversify your investments. Diversification reduces your portfolio’s market risk. Regardless of what the market does, diversification keeps a portfolio healthy. The market may fluctuate, but a portion of your portfolio may respond positively and offset some negative effects.
Cash is where you stay.
As a result of this mistake, panic selling is compounded. After a market downturn, stock prices often rebound strongly, showing how bailing out can cost you when the market turns around.
To be fair, holding cash makes sense if you have short-term spending needs or are building an emergency fund. When your long-term financial goals are decades away, it makes no sense to hold a large position in it as part of your investment portfolio.
It is advisable for investors who have excess cash because they sold during the market slide, or for any other reason, to close the gap and invest. It is possible to get back into the market gradually by buying set amounts of stock at regular intervals (say, monthly) using dollar-cost averaging.
In many cases, dollar-cost averaging can make it easier for fearful investors to move out of cash, since they won’t have to worry about putting lots of money into the market, only to see it sell off again. As a result, if the market recovers, they will be glad they already put some of their money back to work rather than leaving all of it on the bench.
You don’t consult an investment professional before making a large investment.
As humans, we all make mistakes. And, occasionally, we make these mistakes because we all let our emotions get the best of us. In the end, though, you’ll get into trouble when you make decisions based on feelings rather than facts.
How can you keep things in perspective and make sure your investments are on track? Consult a professional for investment advice. When you have a pro on your side, you’re more likely to stay focused on your long-term goals and stay as cool as a cucumber.
What is a recession?
After a period of growth, a recession is typically defined as two consecutive quarters of declining GDP (gross domestic product).
According to the National Bureau of Economic Research (NBER), a recession is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.”
What causes recessions?
Many things have led to recessions in the past, but economic imbalances are typically the cause. For instance, the 2008 recession was caused by excess debt in the housing market. Unexpected shocks can also lead to job cuts, like the COVID-19 pandemic.
Economic growth, earnings and stock prices are all put under pressure when unemployment rises. An economy can be thrown into a vicious cycle by these factors. In the long run, recessions are necessary to clear out excesses before the next boom.
How does a recession affect the stock market?
Although recessions are hard to predict, it’s still smart to think about how they might affect your portfolio. Historically, bear markets (market declines of 20% or more) and recessions (economic declines) have often overlapped, with equity markets leading the economic cycle by 6 to 7 months on the way down and back up.
Even so, market timing moves can backfire, like moving an entire portfolio to cash. It’s often the late stages of an economic cycle or right after a market bottom that yield the best returns. In down markets, dollar cost averaging, where investors invest equal amounts at regular intervals, can help. Investors can buy more shares at lower prices while staying positioned for when the market recovers.
How long do recessions last?
Since 1854, the average recession has lasted 17 months, according to the NBER. Generally, recessions in the U.S. have lasted about 10 months since World War II, with recessions typically lasting much shorter.
However, a recession can last much longer than that. For example, the Great Recession of 2007 – 2009 lasted 18 months. Conversely, it can last only a short time. The COVID-19 recession of 2020, for instance, lasted for only two months..
What should you do to prepare for a recession?
Before and during a recession, investors should remain calm. It’s especially true during times of economic and market stress that emotions can sabotage investment returns.
Although recessions can’t be predicted, it’s important to maintain a long-term mindset. Ensure your portfolio is designed to be balanced so that you can take advantage of growth periods before they happen while remaining resilient during volatile periods.
Article by Albert Costill, Due
About the Author
Albert Costill graduated from Rowan University with a History degree. He has been a senior finance writer for Due since 2015. His financial advice has been featured in Money Magazine, Fool, The Street, Forbes, CNBC and MarketWatch. He loves to give personal finance advice to millennials.