Don't be one of those investors who sabotages themselves by selling their stocks during a recession. That's a quick way to bring down the long-term performance of your portfolio, and it's at odds with proven methods to achieve the best possible returns.
It's not easy to do, but the path to growth is clear: Remain calm when a recession hits, think about stock market history, remove emotion from your decision making, and get your portfolio set up to profit.
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1. Emotional reactions can be costly
Recessions and market crashes induce panic and fear, and emotion-fueled decisions usually aren't the best ones. After getting burned, you might get tired of seeing your savings washed away. That's a normal reaction, but giving into your emotional instincts will probably lead to unwanted outcomes.
There are decades of research on portfolio allocation and economic cycles. Cycles are a natural part of our complex modern economy, and stock investors are bound to experience volatility. It's not a valid investment strategy to panic and sell off your assets after the bad news has already been digested, especially if you knew ahead of time that the bad news was inevitable at some point.
Your stock market strategy should be built on objective observations about stock behavior and the nature of the market. Don't throw that out the window at an emotionally charged time. You'll probably regret it.
2. It's only temporary
Giving into fear can also prevent you from unlocking the long-term potential of the stock market. Recessions are by definition temporary, and even the worst depressions have turned around as the global economy marches onward. Correspondingly, the S&P 500 has always delivered positive returns over 10- to 15-year windows. If you're patient and prepare yourself for periodic bear markets, your investment portfolio will eventually recover.
Even if you don't like the idea of waiting out the volatility during a recession, consider how you might sabotage yourself by selling your stocks. Many of the best trading days occur soon after the worst days in the market, leaving you with a very narrow window to capture that upside. Missing the handful of days with the highest gains can drastically reduce the long-term performance of your account. In the unlikely event you manage to time entry and exit points well, you're still incurring higher costs from commissions, fees, taxes on realized gains, and the bid-ask spread.
Opportunity cost is highest when the market is down, and selling during a recession means that you'll lock in your losses. Nobody wants to buy high and sell low. Not only should you hold onto your investments, you should take the opportunity to buy more if your financial plan allows you to do so.
3. Your stock portfolio might even grow during a recession
Waiting around for an economic recovery might not seem appealing. Luckily, the market has also grown during recessions in the past, so you might not even have to wait for the long-term narrative to play out. A recession just about guarantees volatility in the stock market, and there will be days when your portfolio loses value. However, the market is typically forward-looking, and it will bounce back on early signs of recovery if stock valuations are attractive.
We don't need to look any further than 2020 for a clear example of this. Major stock indexes dropped sharply in the first quarter as the pandemic threatened the global economy. As we learned more about the disease and many companies adapted, the market quickly erased all of its losses, even though we were still experiencing a recession.
Data by YCharts.
4. Income investments still perform
It might be ugly to open up account statements and see a lower value. However, some assets will still deliver positive returns when the market is down. Many dividend stocks continue to send quarterly checks to shareholders. The Dividend Aristocrats have managed to repeatedly grow their distributions through several recessions.
Many people also have bonds in their investment portfolio. A well-constructed bond portfolio still produces interest income. These securities also tend to experience less volatility than equities.
Income-generating assets can help you weather temporary storms. If a recession is sending shockwaves through your financial plan, you might want to consider a temporary focus on the income created by your assets. Retirees can source cash from passive income rather than selling off their holdings. It's easier to have peace of mind if you know that at least some positions in your portfolio will keep chugging along even in times of chaos.
