There's no way for investors to avoid recessions. Economic cycles are natural, and they can move the market drastically. That doesn't have to be a bad thing, though! Investors can use a few important strategies to limit losses and maximize long-term gains.
1. Stay invested
This is the most important strategy on the list, by far. It's also probably the most simple one. The stock market is likely to drop during or immediately following a recession. Our human instinct is to take action to stop the pain. It's not easy to do, but the best move is generally to fight this instinct.
The worst time to sell a stock is right after it's dropped. All that does is lock in your losses. The best time to sell has already passed, and chasing that is an irrational fear reaction -- it's already too late. You might prevent further losses, but you could also lock yourself out of the gains from the inevitable market recovery. Some recoveries take years following prolonged, steep crashes. Other ones are immediate, but either way, it's nearly impossible to know which one you're dealing with in the moment.
Suppose that nothing has changed about a company's expected future cash flows or financial health. For long-term investors, that means nothing has changed about the stock's potential. A drop in price just means that it got even cheaper, and, perhaps, less risky. From a purely rational perspective, a recession is one of the worst times to sell.
Even investors who recognize this logic can still be tempted to time the market. There's tons of data out there suggesting you probably can't do that successfully over the long-term. Instead, it's generally best to trust that the market will turn around as economic conditions inevitably return to growth.
2. Hold dividend stocks
Dividend stocks are great additions to investment portfolios, especially during market downturns. When investors' risk appetite declines, capital usually flows toward value stocks and other stable businesses. Dividend stocks become more popular when market turmoil is on the horizon. That's exactly what we saw in early 2022.
Dividend stocks also bring the major benefit of performing during market crashes. Your portfolio might get crushed and lose value on paper, but you can still enjoy cash returns, regardless of share prices. This is really important for retirees relying on investment income. It's also a great way to calmly stay invested as you wait for the stock market to turn around. You'll be less tempted to sell if some of your stocks are kicking off cash.
Recessions can threaten the profits and financial health of any business, which can cause them to slash dividends. Make sure your dividend investment strategy retains some exposure to defensive stocks, such as healthcare, consumer staples, and utilities. These are considered non-cyclical because their sales tend to remain more stable across economic conditions.
3. Manage volatility
This is an important investment strategy to consider before a recession hits. If you don't take care of this, it might be too late. Volatility is an inevitable part of stock investing. The market moves in cycles, and crashes tend to coincide with recessions.
You can't avoid volatility, but you can definitely manage it. Investors can measure their risk tolerance based on time horizon, financial needs, and personal tastes. If you don't need to access your stock investments for a long time and you don't mind short-term losses, then you can invest for aggressive growth. If you'll need to sell your stocks for cash soon (or if you just can't handle losses emotionally), then it's important to balance your allocation in alignment with your risk tolerance. Bonds are a popular asset class for volatility reduction.
If you missed the boat on this step in 2022, make sure you're prepared in the next market cycle. It will be relevant again in the future.
4. Stay liquid
If we're truly entering a recession, then it could be wise to keep some "dry powder" on the sideline. You'll be thankful if you have cash on hand when the market approaches its bottom. Don't mistake this for a recommendation to sell off your stocks and violate the first section of this list. With the market down 13% year to date, it's not exactly a good time to sell stocks anyway.
Instead, approach this as a form of volatility management. If you're overexposed to stocks, then it might be smart to take some gains on stocks that have outperformed recently. That cash can be deployed into better opportunities, such as stocks that have recently become undervalued. Energy stocks could fit this description after their recent inflation-fueled run-up.
5. Buy cheap, promising growth stocks
If you have some cash on hand after the market takes a beating, then it's time to consider undervalued growth stocks. Growth stocks take a beating during crashes, but they tend to outperform the market during bull periods.
Artificial intelligence, data analytics, cybersecurity, and fintech stocks are way below their 2021 highs. They might have more room to tumble, but the risk-reward balance has flipped. Valuations are much more rational, and these industries are among the most promising for the next few decades.
If you do some homework and have high conviction in a few of these names, it's a great time to consider adding them to your portfolio for the long term.