As the COVID-19 pandemic so abruptly reminded us, the economy doesn't always grow, and the stock market doesn't always rise. Indeed, a falling stock market often goes hand in hand with a declining economy, as stocks are ultimately priced based on people's expectations for the future. When times are tough, their expectations get lowered, depressing share prices.
With that in mind, it takes a special mindset to effectively handle your investments during a recession. You have to keep focused on the fundamentals, be prepared for things to go wrong with the companies you own, and recognize the risks a recession can have on the rest of your financial situation. These five steps to handing investments in a recession can help you improve your chances of getting through the tough times intact. Doing that successfully positions you well to profit during any subsequent recovery.
No. 1: Have an emergency fund
In a recession, jobs often get cut. If yours gets cut, you'll need another source of income to cover your costs until you can find replacement employment. If all you have are your stock investments, then you risk being forced to sell your stocks while they're down in order to pay a bill that's immediately due. An emergency fund of three to six months of living expenses provides you cash to handle your immediate needs.
It also gives you flexibility to adjust the rest of your financial situation in the event your period of joblessness turns out to last longer than you initially hoped. If you do wind up having to liquidate investments, having an emergency fund to use up first gives you the gift of time to pick which investments you're most willing to sell first.
No. 2: Know how your companies make money
A share of stock is an ownership stake in a company. Over time, its value is based on the company's ability to earn money. In a recession, that company's ability to earn money may be negatively impacted, which could hurt its stock price.
With a good understanding of how your investments make their money, you can get a better handle on how deeply a recession is likely to impact their businesses. You can also learn what levers they have available to adjust to ride through the recession and whether they have the flexibility to actually emerge stronger once the recession ends.
This can also help you make rational decisions on whether you want to hold on to your investments, buy more while their prices are cheaper, or lighten up your holdings and reinvest in better prospects. When you know how your companies make money, you can make much more rational buy/sell/hold decisions than if you're just focused on their stock price action.
No. 3: Keep an eye on your investments' balance sheets
A company's balance sheet lists two key sets of information: What it owns and what it owes. When times are good, having a strong balance sheet may feel like overkill, but during a recession, it may mean the difference between a company surviving or declaring bankruptcy.
Key things to look for in a balance sheet include:
- Its debt to equity ratio, which measures how much it owes (debt) compared to how much it owns above and beyond what it owes on it. Think of it like your mortgage: if you put 20% down on your house and took out a mortgage for 80%, you have a 4 to 1 debt to equity ratio on it. The lower that ratio is, the stronger the company's flexibility to ride through a hiccup in its operations.
- Its current ratio, which measures how much it has in current assets like cash and receivables compared to how much it has coming due within the next year. The higher that ratio, the better the company's ability to make it through a short term disruption in the corporate debt financing market.
- Its debt maturity schedule, which tells you when its debt is coming due and how much is due at any given time. That can help you see if it is facing any huge payments in the near future that it may not be able to cover from current assets and cash flows. If the corporate debt market dries up, debt coming due that's too large for a company to pay off can force a default even if the company could otherwise continue to service its debt.
No. 4: Stay diversified
Rental real estate of many types have been hit hard by the COVID-19 pandemic. Many companies shut down and lost their ability to generate revenues to cover their rents. Many people lost their jobs and similarly lost their ability to pay their rents. Even medical facilities -- generally considered recession resistant -- were affected as many states shut down all non-essential healthcare services.
In the financial meltdown that led to the last recession, housing prices fell and banks, lenders, and financial institutions that leveraged themselves to home prices were disproportionately hit. In the tech wreck that preceded that, Internet-focused businesses found themselves hurt harder than many of the bricks and mortar companies that they were actively disrupting.
The point behind that is that while recessions happen, they don't always have the same causes, and depending on the cause of the current crisis, different companies and industries can get hit the hardest. You can't always figure out what will cause the next crash and get out of those investments in time, but what you can do is keep your portfolio diversified by investing across industries.
That way, when things go wrong and you find yourself invested in a business or industry that's collapsing, it doesn't ruin your entire financial picture. Diversification won't help you improve your returns during the good times, but it can sure help protect you from the worst impact of a downturn when it affects a company or industry you own.
No. 5: Take your dividends as cash
Many companies offer their owners dividends as a tangible financial reward for the risks they're taking by investing. Often, investors reinvest those dividends automatically to keep that money compounding in a company that's successful enough to pay those dividends. In good economic times, that can be a great idea, but when times are tough, consider taking those payments as cash, instead.
The dividends you receive as cash can be invested in any company you choose, not just the one that paid that dividend to you. That will allow you to choose where to put your money, which gives you the opportunity to buy solid companies that the market has unfairly knocked down, without having to raise additional cash. It also gives you cash to help cover your costs should you find yourself unemployed and in need of a way to pay your bills while you're living without your salary.
We've made it through recessions before
The important thing to remember is that even though the economic slowdown put in place to combat COVID-19 is painful while we're going through it, we've survived plenty of recessions in the past. If past pandemics are any guide , this too shall pass at some point, and we will find ourselves on the road to recovery. By following these five steps, you can improve your chances of staying invested throughout the recession and emerging from it with your overall portfolio generally intact.
As the old saying goes, fortunes aren't made in bull markets -- that's just where they get revealed. Those that truly build wealth are those that can invest -- and stay invested -- no matter what the economy is doing. These five steps can help you better handle your investments during a recession and give you a fighting chance of building and keeping the foundation of your own solid financial future.