Investing during a recession can be a profitable endeavor for those entering the stock market with a long time horizon and the right investment strategy
The coronavirus pandemic has touched every aspect of our lives. The stock market in particular experienced a substantial hit. These circumstances, however, also represent an investment opportunity with the potential for a steep upswing when the market eventually recovers.
New investors with cash reserves are especially well positioned to take advantage of recession conditions, buying stocks when prices are low and holding on to them at least until the economy recovers.
Like in many other areas of business and personal life, adequate preparation is crucial for successful investments. A combination of general knowledge of market fluctuations, and specific research on the investments under consideration are key components to this preparation.
This article, intended for beginning investors and people considering buying stocks for the first time, provides some tips and aspects to consider when investing during a recession.
Keeping a Long-Term Perspective
Smart investing during recession markets is achievable with the right strategy. A well thought out investment strategy must be in place before investing even the first dollar.
During the best of times, the stock market is unpredictable and chaotic, especially if we only look at short intervals. Recessions tend to drive the price of stocks down, particularly during the initial stages and in the middle of a recession, even though there may be performance differences between industry sectors and among the stocks of individual companies within each sector.
To take advantage of the selloff created by a recession, it would be important to develop an investment plan that considers the following factors:
Define Your Investment Horizon: How long do you plan to hold this investment? Is it for a year, three years, or is it going to be longer? The market may continue to drop, or start to recover, which is difficult to know in advance. However, stocks held for periods of four years or longer are more likely to experience substantial gains in the long term, so sticking to your timeline is a good way to avoid making rush decisions. Defining the appropriate circumstances to exit a given investment would be also important.
Know Your Risk Tolerance: If you were to lose a substantial part of your investment, would you still be able to cover your basic needs and the needs of your family with alternative sources of revenue? Determining how much risk you are willing to take with your money is an important part of an investment strategy, and there are plenty of investment opportunities at every level of the risk spectrum.
Look Toward the Future: It is important to look at what companies are doing to become profitable. Financial expert Howard Silverblatt, of the S&P Dow Jones Indices, said “Stocks move on anticipation of where people think the economy is headed, not where it is at the moment.” While no one really knows what our economy or society will look in the future, identifying emerging or established companies with the potential to be market leaders in growing industries in a few years are worth exploring as possible long-term investments.
Do Your Research: Research is key to determining the best companies to invest in. This may include reading the reports and recommendations from financial analysts, identifying chart patterns through technical analysis, reading news, interviews with experts, and reviewing the fundamentals of a company via indicators like levels of debt, quarterly earnings, and price to earnings ratios, among others, along with qualitative factors. For instance, when looking at levels of debt, is the debt used to cover bloated operational expenses, or is the loan money used to scale up successful operations?
Create a Watchlist: Once you have found some stocks that fit your investment strategy, watch them and track how they perform for a given period. You can use paper trading or investment simulators to facilitate the tracking process. If they show up in financial news articles, read about them. If you like how the stocks are performing and they fit your investment strategy, they may be the right investment for you when it is time to buy.
Stick to Your Planned Investment Strategy: One of the biggest mistakes new investors make is getting into or jumping out of the market as a reaction to their market anxiety, without a plan. If you look at the financial crisis of 2008, those that could afford to stay in the market and resisted the urge to cash out not only made their money back, they ended up coming out ahead within 18 months or so.
Recognizing the Variation Across Industries
Different industries are affected differently during a financial crisis, since each sector has its own market dynamics. Even though the COVID-19 recession is unique compared to other financial crises, there are commonalities you can look at to make money during a recession.
Here are some sectors to consider while conducting your market research:
Technology: While technology stocks may experience significant levels of price fluctuation, such volatility also represents an opportunity. If bought at a time when they are close to the market bottom, their upswing potential once the market recovers could be substantial. Bear in mind, however, that some technology stocks may respond to specific dynamics associated with their particular position in the market.
Consumer Staples: Essential businesses like grocery stores and consumer goods remain active during recession times. People still need them, even though the options available and their overall volume of sales may be reduced. The elasticity of the demand and the availability of close substitutes for certain products are also factors to consider. While the upswing of stocks in this sector may not be the greatest once the economy recovers, it may provide some resilience to a portfolio built with defensive considerations in mind.
Utilities: According to a New York Times article, utility stocks were one of the best performing sectors on the S&P 500 in the first two months of the coronavirus pandemic. While not much growth is usually associated with them, some may offer significant dividends. An important aspect to consider, however, is that some utility companies have investments in sectors that may have different performance levels than the ones associated with the utility service.
Precious Metals: During the 2008 financial crisis, gold had a historic rise in its value, as did silver during the COVID-19 crisis. As an alternative to actually buying the precious metals themselves, or the futures contracts associated with them, there are other ways, like Exchange-Traded Funds (ETFs), which you can use to invest in precious metals.
Understanding Market Fluctuations
The United States economy has usually displayed a cyclical nature. The last cycle had a downturn from 2007-2009, and then there was an upswing between 2010-2019. COVID-19, on the other hand, produced an off-cycle disruption of the economy. The best way to face these cycles, however, is to stick to your investment strategy, and consider that long-term investing is usually more advantageous and resilient than short-term speculation.
While buying shares when the stock market is at a low point makes sense, there is no easy way to see if the prices will keep dropping or assess how long it will take until the market recovers. Estimates and predictions regarding these cycles involve substantial levels of uncertainty.
To address this uncertainty, a widely recognized approach is using a dollar-cost averaging technique. Buying shares in several installments at regular intervals can average your purchase prices out. Sometimes the prices may be higher than others, for the same stock, but if you buy at different times, your average cost could be advantageous in the long term.
Something to consider when stock prices are low is buying stock substitutes, option calls that are deep in the money, also referred to as LEAPS. In simple terms, this would resemble making a substantial down payment for the right to buy a number of stocks at a later date, which can be a couple years later or more, without requiring investors to pay the full cost until the option is exercised, allowing investors to maximize their available cash while stock prices are low.
To reduce the level of risk when using LEAPS, investors could choose to limit their trades to option calls with a percentage to break even that is less than 2%, which would increase the cost of the premium but also lower the strike price, making it more likely that the option will expire in the money. It would be even better if the percentage to break even were to be negative, which would mean that the total cost of the option (premium plus strike price) is lower than the market price of the underlying stock.
Two key aspects to note when using options, however, are that the minimum number of stocks in one option contract is 100, and that the cost of the premium to buy that stock at the strike price –the fixed price the investor agreed to pay for the stocks– may be a substantial percentage of the total cost of the stock, multiplied by 100, which represents an important cash commitment.
For those investors with greater risk tolerances and confidence in their analyses of stock market trends during recession times, using margin to buy stocks when prices are low is another mechanism to leverage their investment potential. This approach should be used with considerable caution, however, since the risks of margin investment are significantly higher than when using cash, and there are no guarantees that the purchased stocks will recover to the levels they had prior to the recession.
Diversifying the investments across different industries and different types of securities, like stocks, ETFs, and index funds, for instance, may also contribute to reduce the level of risk of a portfolio.
Because the stakes are high, even experts tend to get cautious during recessions. There are no guarantees, and even the apparently most stable stocks involve some level of risk. That is why defining a solid investment strategy and keeping the course over recession periods is important, since it can counteract the tendency to exit the market at the wrong time because of fears.
People uncomfortable with making investing decisions on their own can also benefit from the expert advice provided by licensed financial advisors with experience in the type of securities in which you are planning to invest. They can assist you in building your investment strategy, find stocks that fit your investment plan, provide information about stocks you may not know about, and help you identify potential pitfalls throughout the process, like tax implications.
An important point to consider regarding financial advisors, however, is related to the way they are paid. Some of them are fee-only registered investment advisors (RIA), which are preferable, since they have a fiduciary responsibility to act in the best interest of their clients. Other advisors receive commissions from the sale of the investments they recommend, which in some cases may pose a conflict of interest and their advice may not always reflect their client’s needs.
The more knowledge you have about investing in the stock market, however, the better positioned you will be to make informed financial decisions. Whether gaining this knowledge on your own, or using investing advisors as a sounding board, it is wise to retain control to make all final investment decisions. The good thing is that there are many available resources for individual investors to educate themselves on how the stock market works.
Disclaimer: The contents of this article are provided for educational purposes only and are not intended to be investment, tax, or legal advice. This article neither recommends the purchase or sale of any security or investment, nor includes the analysis of financial securities. Any action taken upon the information on this article is strictly at your own risk. Readers interested in obtaining investment advice should seek a duly licensed investment advisor.