Economic recessions often coincide with downturns in the stock market. During times of economic uncertainty, many people want to know if they should change their investment strategy.
During a recession or a market downturn, long term investors are best served by doing nothing. The last thing you want to do is sell when the market is down. Doing so would turn paper losses into real losses. Rational investors hold their investments and wait for the market to recover.
In this post, I’ll reveal the three things a recession will tell you about your financial plan and review the risks and opportunities for investors during times of economic uncertainty.
The stock market is not the economy
The first thing that investors should know when the economy goes into recession is that the stock market will often move in the opposite direction as the economy on day to day basis.
Meaning the stock market could begin increasing even as the economy continues to struggle.
To understand why that is, you need to know two things.
Economic data is backward-looking. When economists publish statistics about the current level of unemployment or GDP, they are using data that is weeks or even months old.
Stock prices are forward-looking. Stock prices are a reflection of the market’s expectation of a companies future earnings.
Given these two facts, it should not be shocking to see a situation where “bad” economic numbers are reported on the same day that the stock market increases.
If economists release a report that says the unemployment rate has gone up, that does not mean the stock market will necessarily fall on that news.
The unemployment statistic is using data that could be a month old.
A month ago, companies, analysts, and investors would have been aware that the unemployment rate was going up, and that fact would already be reflected in stock prices.
The primary impact that backward-looking economic data has on stock prices is if the data was better or worse than what investors expected.
If the market priced in 5 million job losses, and it turns out only 4 million people lost their job, the stock market might rise because things are not quite as bad as investors thought.
On the other hand, if the data reveals 10 million people lost their job, then the market will likely fall because that would suggest the economy is in worse shape than what investors priced in.
Three things a recession will reveal about your financial plan
If your emergency fund is big enough.
If you are carrying too much debt.
If you are taking too much risk in your investment portfolio
If you’ve lost your job or believe you might lose your job, you’ll know pretty quickly if you have enough cash on hand or if your debt load is too high.
If you watch your investments decline by 40% or more, you will also be able to tell if you are taking too much risk in your investment portfolio.
When the market tanks, monitor your stress levels
Here is a simple way to get an idea if you are taking more risk than you should in your investment portfolio. If you lose sleep based on a stock market crash, you probably have too much risk in your portfolio.
I invest 100% of my retirement fund in stocks, which is a risky asset. This is a sensible choice for me for many reasons, but primarily two critical points.
I have decades before I reach retirement age, which means I can ride out extreme volatility in the short run.
I am incredibly comfortable handling these periods of volatility.
In 2020, I watched my investments drop by 35% in value of a period of a few weeks. That is a level of volatility not seen in decades, even during the financial crisis, where the drop in the stock market was significant but drawn out over a more extended period.
At no point during that market crash did I feel the slightest bit of panic or consider selling any of my investments. That market crash was the confirmation that I can handle a high degree of risk in my portfolio.
The biggest risk to your investments is not a recession; it’s you
A recession has never destroyed an index investor’s portfolio. Only the investor themselves can do that.
Economic cycles move from periods of prolonged growth to economic recessions. Sometimes those recessions can be severe and are usually accompanied by some scary narratives that lead people to believe “this time is different” or that the economy will never recover.
While the cause, severity, and length of each recession is different, it has always ended one way with the economy and the stock market recovering and continuing their path to growth.
That’s why “behavioral risk,” the risk that investors will make fearful decisions to sell at the bottom, is a more significant investment risk than any recession. Here is how many investors respond to a recession
The stock market goes in the tank. Investors get scared and sell at the bottom. This turns paper losses into real losses.
Then, they sit on the sidelines and watch as the stock market recovers. Since the stock market (forward-looking) often recovers faster than the economy (backward-looking), they miss out on some of the best months to be invested in the stock market.
Once the economy feels more stable, they think it is “safe” to get back into the stock market, and they buy when prices are high.
In short, they sell-low and buy-high, which is the exact recipe to have lousy investment returns.
How to avoid the sell-low, buy-high trap
Let’s remember why people sell their investments at the worst possible time; they are afraid.
If you are so afraid when markets drop that you are tempted to sell your investments, then that is a clear sign that you have too much risk in your portfolio.
The simple solution is to reduce the level of risk in your portfolio to something that you can handle during the most volatile times.
Vanguard has developed a free tool that helps you determine how much risk you should have in your portfolio. This enables you to determine the right allocation between risky assets like stocks and less risky assets like bonds.
Yes, by reducing the level of risk, you will be giving up higher expected future returns. But remember, the higher expected returns in risky assets like stocks mean absolutely nothing if you are so scared by the inevitable volatility in the stock market that you sell at the worst possible time.
If you can afford it, working with a financial advisor is an excellent way to manage behavioral risk and avoid the sell-low, buy-high trap. A great financial advisor can act as a coach and prevent you from selling at the worst possible time during recessions and market crashes.
This is where financial advisors earn their paychecks. When the economy is firing on all cylinders, and everyone is making money, it can be difficult to see the value of working with an advisor. When the economy turns south, and people get scared, a financial advisor can provide tremendous value by saving you from the greatest risk to your portfolio; you.
Downturns are a fact of life
Economic recessions and market crashes will happen from time to time; that is a fact that anyone investing in the stock market must accept. It’s important to remember, though, that the stock market and the economy will not always move in the same direction at the same time.
When the stock market crashes, you will be able to tell if you have too much risk in your portfolio. Investors with the appropriate amount of risk will hold their positions or even look to invest more money when the market is down. Investors with more risk than they can handle will think about selling.
Whatever you do, don’t sell and lock in losses. Do everything you can to ride out the period of market volatility. When markets recover, it will be wise to rethink your asset allocation to ensure you are carrying the appropriate amount of risk in your portfolio.
If you can afford it, working with a financial advisor is a great way to manage behavioral risk.
Remember, if your investments are adequately diversified, a recession or market crash is probably not the thing that will destroy your portfolio. You are the most significant risk to your portfolio because, as a human, you are prone to irrational fear-based decisions. Recognizing that is the first step to becoming a successful investor in any market condition.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.