Worried about economic weakness ahead? You're not alone. The United States' GDP growth rate slumped to a mere 1.1% last quarter, coming in below expectations as well as under long-term norms. Economists are worried too.
Investors don't need to panic, however. They need to plan. Here's a rundown of five measures to consider if you're looking to defend your portfolio from a recession, from least important to most important.
5. Shed your wobbliest holdings
It's a mistake to sell all of your stocks before (or during) a recession simply because recessions are trouble for the market. But it's not wrong to dump your lower-quality holdings that are more vulnerable to marketwide weakness.
That doesn't mean your higher-quality holdings are immune to sweeping pullbacks. It's simply to point out that putting pressure on all stocks separates the winners from the losers. Higher-quality stocks tend to hold up better and should bounce back sooner once the market begins recovering.
One caveat: Be wary of trying to perfectly time these exits, or making them preemptively. Lots of investors and even economists predict recessions that never actually materialize.
4. Consider selling covered calls
The middle of a recession is the wrong time to begin learning about equity options. If you're already familiar with them, though, covered calls are a great way to monetize your existing stock holdings that may be temporarily losing ground.
Options are essentially bets that a stock will reach a particular price level within a specified period of time. Call options gain in value as the underlying stock does, while put options gain value when that underlying stock falls. Investors pay to own calls or puts, with the hopes of selling them back later at a higher price (or using them to purchase or sell that stock at a better-than-market price). But you can also sell calls and puts short, collecting money upfront. As with any other kind of short sale, though, there's extreme risk. That risk is, you may be forced to purchase or sell those underlying shares at a lousy, losing price.
Covered calls are a different sort of trade, however. With a covered call, you're selling call options on stocks you already own. As long as that stock continues to underperform (which is often the case in a recession), you can continue to drive income without being forced to sell your long-term stocks. But if for some reason they start performing well and you're forced to sell them, you've still collected some cash payments, and you can always buy those stocks again.
Confused? Don't sweat it -- options can be complicated, but anyone can learn how to trade them. You just don't want to begin learning about them by putting your portfolio at risk. The time to figure them out is beforehand, with several hypothetical "paper" trades first.
3. Ramp up your exposure to dividends
Options aren't the only way to generate income in the midst of a recession, of course, and certainly not the easiest way. Dividends do a far better job, even if they don't generate quite as strong of a net yield as covered calls can.
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This doesn't mean you should convert your entire portfolio to dividend-paying holdings. Plenty of growth stocks are worth holding even during the market's tough times.
In an environment where capital appreciation is difficult to come by, though, collecting at least a little cash is better than nothing. Just bear in mind a stock's dividend isn't the only consideration. Those shares still represent a company that must be worth owning no matter the circumstances.
2. Make sure you're properly diversified
The value of diversifying a portfolio isn't readily apparent when the market's bullish. When a recession is putting prolonged bearish pressure on stocks, however, the need for diversity becomes crystal clear. While most stock sectors struggle when the broad market tanks, a well-diversified portfolio prevents one stock or one sector's implosion from being downright painful.
Diversification isn't just a matter of spreading your money across several industries, though. Where many investors end up missing opportunities is in not owning non-stock holdings like bonds, real estate, or commodities. Not only are these other areas not tightly tethered to the same cycles that lift and lower stocks, but they often move in the opposite direction as the stock market does. These alternative assets can very easily move higher during a bear market for stocks.
1. Be confident in the market's long-term track record
Finally (and most important), doing nothing is an acceptable strategy for your portfolio when things turn rocky.
Don't misunderstand. If your portfolio looks the same when a recession is looming as it does when the economy is booming, it'll take the obvious toll. Sometimes, however, taking your lumps is the best option. Worse than suffering a sell-off is missing out on the eventual, inevitable rebound to the market's next record high.
To this end, only once in the past several decades has the S&P 500 lost ground over any 10-year timeframe. That's 2007-2008, when we were in the throes of the subprime mortgage meltdown. Over the course of any 20-year stretch the index has never lost value.
And you certainly don't want to be left wondering if the market's made its bear market bottom or not; you can't afford to be wrong. Numbers dug up by mutual fund company Hartford indicate one-third of the market's very biggest daily winners take shape during the first two months of a new bull market. Brokerage firm Edward Jones adds that the S&P 500 has logged an average gain of 25% during the first three months of the past five bull markets.
Not overreacting to what will only be a temporary headwind makes good sense. You don't want to be on the sidelines once the market turns itself around.
