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What to invest in during a recession?
Recessions suck! But as long-term investors, we have to manage our portfolios in every type of environment. In recessions, we can look towards defensive investing.
Quote
"A defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market."
You can think about investing like a football pitch. It's split into two halves. The opposition half is a bull market, your own half is a bear market. While you’re in the opposition’s half you want to score a goal and you’re on the offensive. When you’re in your own half you want to be defensive.
Where to invest during a recession is the defensive areas of the stock market.
Big ideas
- In a recessionary environment, defensive stocks tend to outperform the overall market because they are less volatile and more stable.
- Industries well suited to defensive investing include healthcare, utilities, consumer staples, telecommunications, infrastructure and transportation.
- Being in the right kind of stocks for a recession needs to be done with specific defensive strategies such as prioritising quality and diversification.
What is defensive investing?
Defensive investing is an investment strategy that aims to protect your capital and minimise losses in a downturn. It involves investing in companies that are less likely to be affected by an economic recession. Characterics of companies that make good defensive investments include producing essential goods or services, having low debt or industries that don’t rely on consumer spending.
Finding the best investments during a recession
When recessions occur, the stock market often takes a hit. However, not all stocks are equally affected. Some companies tend to weather economic downturns better than others. As a result, investors allocate more of their capital to the stocks of those companies.
Because defensive stocks are less volatile and more stable during recessions, they tend to outperform the overall market. As an investor, you can take advantage of this by investing in defensive stocks during a recession.
Because defensive stocks are less volatile and more stable during recessions, they tend to outperform the overall market. As an investor, you can take advantage of this by investing in defensive stocks during a recession.
How to invest during a recession avoiding these stocks
Knowing what not to invest in can be as important as knowing what to invest in during a recession. The following are characteristics of stocks that you ideally want to AVOID or own less of when the economy is weak.
1. Cyclical stocks
These are the shares of companies that produce goods or services that are sensitive to economic cycles. For example, companies in the automotive and housing industries are typically cyclical because people tend to spend less on big-ticket items when the economy is weak. These stocks are generally more volatile and risky, so they tend to do poorly in a recession.
2. Speculative stocks
Speculative stocks represent companies that have not yet fully developed their product and might still be unprofitable. In some cases they are unlikely to make a profit for several years because they are heavily investing in future growth. These companies are usually start-ups or small businesses with high risks and high potential rewards.
A good example are biotechs, which spend lots on R&D in the hopes of creating a new drug that either cures disease and gets approved by regulators or doesn’t work and the company is worthless. They tend to do poorly in a recession because investors are more risk-averse and prefer to invest in established companies with a track record of success.
A good example are biotechs, which spend lots on R&D in the hopes of creating a new drug that either cures disease and gets approved by regulators or doesn’t work and the company is worthless. They tend to do poorly in a recession because investors are more risk-averse and prefer to invest in established companies with a track record of success.
3. Highly leveraged stocks
These are the stocks of companies with a lot of debt relative to assets. The debt makes them more vulnerable to a downturn because if revenues fall they may not be able to make their interest payments or meet their other financial obligations. As a result, these stocks tend to lose value in a recession.
4. Stocks of non-essential goods
These are the shares of companies that produce luxury items or discretionary items that people can live without. For example, people may cut back on buying expensive clothes or going out to eat at restaurants during a recession. These stocks tend to underperform in economic downturns because people often have less money to spend.
Watch our video
Sectors: What to buy during a recession
Investing in defensive sectors should put you in a better position than investing in risky areas that depend on high confidence in a strong economy. How to make money in a recession hinges a lot on the sectors you invest in.
1. Healthcare
People need to take care of their health regardless of the state of the economy. They still need to go to the doctor or buy medicines, even when times are tough. That means the companies that offer healthcare services tend to be less volatile and more stable, making them suitable defensive investments. Note that not all healthcare companies are created equally. Well-established healthcare businesses with a diversified product line are defensive investments but smaller companies like biotechs are not.
2. Utilities
Utilities are another example of companies that provide essential goods and services that people need regardless of the state of the economy. These companies are also typically less volatile and more stable, making them suitable defensive investments. For example, an electric utility company is likely to maintain most of its customers in a recession since electricity is a necessity of modern life and as a natural monopoly, switching suppliers tends to be difficult if not impossible..
3. Consumer Staples
Consumer staples are companies that produce goods that people regularly need, such as food and household items. Most households, even those on a tight budget, will still need to buy these items during a recession. As a result, consumer staples tend to do well in an economic downturn. For example, food giant Kraft Heinz or large retail chains like Walmart and Costco have a good track record of outperforming the market during recessions.
4. Telecommunications
Thanks to the advancement of technology, people now rely on telecommunications companies more than ever before. While the industry is not entirely recession-proof, it has still outperformed the market during past downturns. For example, telecom giants AT&T and Verizon are investing in 5G expansion, which will be a necessity for mobile connected devices in the future.
5. Infrastructure and Transportation
Infrastructure companies build and maintain roads, bridges, railways, and other forms of transportation. These companies play a vital role in keeping the economy moving, even during a recession. Government decisions about investment in infrastructure tend to be long term and the budget is allocated and used whether there is a recession or not. Likewise, even when the economy is slowing down, people still need to get around, and businesses still need to transport goods.
Defensive strategies for the best recession investments
How can this information about defensive and non-defensive industries be put to use to make investment decisions? When you’re investing with Trading 212 and you have the help of a tool like Pies, designing a defensive portfolio is very straightforward.
Even if you’re not using Pies yet, you can still think of your portfolio as a pie. Each stock you own is a slice of the pie and you’re just going to slice it up a bit differently depending on whether you’re on the offence or defence.
This simple diagram from Blackrock neatly summarises how you can be more conservative (defensive) or aggressive, depending on the level of risk you want to take.
Even if you’re not using Pies yet, you can still think of your portfolio as a pie. Each stock you own is a slice of the pie and you’re just going to slice it up a bit differently depending on whether you’re on the offence or defence.
This simple diagram from Blackrock neatly summarises how you can be more conservative (defensive) or aggressive, depending on the level of risk you want to take.
Source: BlackrockThe blue is your defensive stocks as we’ve just categorised them and the black are the non-defensive or growth stocks. You ideally want to be more conservative in a recession and then more aggressive when the economy is strong.
What to do in a recession with your portfolio
Being in the right kind of stocks for a recession needs to be done with specific defensive strategies in keeping with your long-term goals. Here are four strategies for how to take advantage of a recession.
1. Prioritise Quality
Prioritising quality means investing in well-established and stable companies with a history of weathering economic downturns. All the financial information about companies in the Trading 212 app makes it is easy to make an audit of your stock portfolio. You just need some criteria to define high quality versus low quality stocks.
There are a few key factors you should look for:
There are a few key factors you should look for:
- A strong balance sheet: This means the company has little debt and a lot of cash on hand. This gives the company the financial flexibility to weather an economic downturn.
- A history of profitability and stable profit margins. This shows that the company can generate profits even in tough economic times.
- A diversified business: This means the company has multiple revenue streams and is not reliant on just one product or service.
- An always-in-demand product or service: This means people still need or want what the company provides even when the economy is weak.
2. Diversify Your Portfolio
Diversification means investing in various Industries and companies so that you're not putting all your eggs in one basket.
For example, if you only invest in a couple of stocks that you think have strong growth potential, you're taking significantly higher risk than if you had say 20 stocks. In a recession those two businesses are more likely to get into difficulties than when the economy is strong. When you own shares in twenty businesses, there is a good chance that some of them will manage the recession well.
Similarly, it would help if you diversified your portfolio across different asset classes, such as stocks, bonds, and cash. This way, if one asset class falls in value during a recession, you'll still have other investments to cushion the blow.
For example, if you only invest in a couple of stocks that you think have strong growth potential, you're taking significantly higher risk than if you had say 20 stocks. In a recession those two businesses are more likely to get into difficulties than when the economy is strong. When you own shares in twenty businesses, there is a good chance that some of them will manage the recession well.
Similarly, it would help if you diversified your portfolio across different asset classes, such as stocks, bonds, and cash. This way, if one asset class falls in value during a recession, you'll still have other investments to cushion the blow.
3. Dollar Cost Average
If you want the ultimate benefit from investing, which is compounding returns, you want to always be adding to your investments over time.
The silver lining to a recession and a downturn in the market is that you can dollar cost average into your investments. By investing a fixed amount of money into your chosen assets regularly, such as monthly or quarterly you will be buying when markets are down, and you can lower your average buying price. Using this approach can help reduce the risk of buying shares at the wrong time and can also help build up your position over time.
The silver lining to a recession and a downturn in the market is that you can dollar cost average into your investments. By investing a fixed amount of money into your chosen assets regularly, such as monthly or quarterly you will be buying when markets are down, and you can lower your average buying price. Using this approach can help reduce the risk of buying shares at the wrong time and can also help build up your position over time.
4. Fundamental Analysis
Finding defensive stocks to invest in requires some fundamental analysis. It involves looking at a company's financial statements and other key indicators to assess its health and prospects. Remember, there’s no harm in taking advice or reading research by others to save time finding such possible investments so long as you check it out yourself too.
Recap
There's no guaranteed way to protect your portfolio during a recession but investing in industries that have outperformed in past recessions while adopting these four strategies will help you build a defensive portfolio that should weather a recession better than if you’d not taken any action at all to get defensive.
FAQ
Q: How often do recessions happen?
When referring to the US, recessions happen on average every five to ten years. However, there have been periods where recessions have happened more frequently, such as the early 1990s and early 2000s. The frequency of recessions can also vary depending on the country. For example, recessions in Australia and Japan have been much less frequent than in the United States but they have been more frequent in Europe.
Q: How long does a recession last?
A recession is technically defined as two consecutive quarters of negative GDP growth. However, the length of a recession can vary considerably. For example, the recession that started in December 2007 lasted 18 months, while the recession that started in 1981 lasted only six months. In general, recessions tend to be shorter in duration than expansions (periods of economic growth).
Q: What’s the relationship between recession and stock market?
Generally, stock prices tend to fall during a recession as businesses cut back on investment and consumers spend less. This can lead to a decline in the stock market. However, there are also times when the stock market may actually benefit from a recession. For example, if interest rates fall during a recession, this can make stocks more attractive to investors.
Q: What to do in a bear market and a recession?
There are a few things that you can do in order to protect yourself during a bearish market and recession:
-Diversify your portfolio: make sure that you are not putting all of your eggs in one basket. invest in different asset classes and sectors in order to mitigate risk.
-Rebalance your portfolio: as stock prices fall, you will want to rebalance your portfolio in order to maintain your desired asset allocation.
-Stay disciplined: it can be tempting to sell everything in a panic during a market crash, but it is important to stay disciplined and stick to your investment plan.
-Diversify your portfolio: make sure that you are not putting all of your eggs in one basket. invest in different asset classes and sectors in order to mitigate risk.
-Rebalance your portfolio: as stock prices fall, you will want to rebalance your portfolio in order to maintain your desired asset allocation.
-Stay disciplined: it can be tempting to sell everything in a panic during a market crash, but it is important to stay disciplined and stick to your investment plan.
Q: What to buy during a recession?
There are a few things that are worth buying during a recession. For one, stocks are typically cheaper during a recession, so it can be a good time to buy into the stock market if investing for the long term. Additionally, real estate is usually cheaper during a recession, so it can be a good time to buy a property.
- Bull Market: A market condition where stock prices are rising, typically driven by strong investor confidence and economic growth.
- Bear Market: A market condition where stock prices are falling, usually by 20% or more, often accompanied by economic downturns and pessimism.
- Profit Margin: A measurement of how much profit a company makes for every pound of revenue earned, after accounting for costs. Stable profit margins can be a sign of strong financial health.
- Volatility: A measure of how much the price of an asset fluctuates over time.
- Growth Stocks (Non-Defensive Stocks): Shares in companies expected to grow at a faster rate than the overall market.
- R&D: Short for Research and Development. It involves investing resources to create or improve products and services.
