It is natural to feel anxious when markets decline. But, over time, the outcome is rarely as dire as initially feared.
Recessions are an inevitable part of the economic cycle, but they can be unsettling for investors. A recession often brings job losses, declining growth and typically an equity bear market. However, it also presents opportunities for the savvy investor. What can investors do to prepare for a recession?
Keep calm and stay invested
As Warren Buffett once said, “Be fearful when others are greedy and greedy when others are fearful.” During a recession, it is essential to keep a level head and avoid acting in panic, which can lead to costly mistakes. History has shown that equity markets do eventually recover following market downturns. Remember March 2020 when the economy came to halt due to the Covid pandemic? Most individuals would not be naturally inclined to buy after such a sharp drop and uncertain outlook. Yet, with the benefit of hindsight, it was perhaps one of the best opportunities to invest.
One question I often get is: should I sell all my equity holdings if we expect a recession and another leg down in equity markets? The answer is no, as no one can predict a recession with certainty, nor can one precisely time the start and end of a market downturn. Betting against the stock market is a risky proposition, as economies and companies generally tend to grow and expand over the long run, providing a positive, secular force for higher stock prices.
Focus on quality
During a recession, when uncertainty and volatility are high, investors can focus more on quality stocks, companies with robust financial positions, manageable debt levels and strong balance sheets. These companies will likely be better equipped to weather a recession and emerge well-positioned for the subsequent economic recovery.
The stability of earnings is another aspect to consider when selecting quality stocks. Companies that demonstrate consistent earnings performance, even in challenging conditions, are more likely to navigate recessions successfully. These are perhaps what Warren Buffet would term as ‘moaty companies’, which possesses durable advantages that allow these companies to maintain stable earnings even in the face of economic downturns.
Investors can also seek out companies with a history of paying dividends. This not only provides a regular income stream, but also indicates financial stability and management’s commitment to shareholders. Dividends are often the last thing to be cut during recessions. It is also often a source of returns during a downturn, especially when capital appreciation may be limited.
Embrace the opportunities
In recessions, investors should also look for bargains. Recessions create opportunities to invest in good companies at a discounted price. As I often like to say, the stock market is the only place where buyers vanish when prices go on sale. Investors who are willing to take advantage of these buying opportunities during a recession can often find fundamentally sound companies selling at discounted prices.
This is important because, when valuations are cheap, future returns are usually higher. The opposite is true when the economy is doing extremely well, driving prices and valuations higher. When stocks are expensive, future returns are generally lower. Hence, somewhat counterintuitively, it is usually attractive to invest more during recessions.
Keeping a long-term perspective
It is natural to feel anxious when markets decline shortly after investing one’s hard-earned money. However, it is important to remember that, over time, the outcome is rarely as dire as initially feared.
We would also not ignore another less apparent aspect of investing: opportunity loss. This concept refers to the potential missed gains that come from not investing or delaying investments. While it may not feel as painful as actual losses, the impact is no less real. The longer one waits to invest, the shorter the time available for returns to compound and grow. Time is a powerful ally to investing and the earlier one starts, the greater the potential for long-term growth.
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