There have been 22 recessions since the turn of the 20th century -- see the table below for a list of all of them (sourced from here) -- and we have currently experienced one of the longest expansion in US history as of early 2017 - by June 2017 we will have experienced an 8-year expansion (almost 96 months) - this is the third longest bull market in over 100 years. Clearly at some point within the next 2 to 5 years, we're going to experience a recession.
This article isn't about 2017 or this latest bull market, however - it's about the economy in general and the fact that things so far have been cyclical. Given the last century of markets, we can safely assume things will continue more or less the same way unless deep structural changes cause some sort of change. These types of changes might be:
Until those things happen, a prudent person would assume a recession will occur when a bull market has been going on for a long time.
Can you predict when a recession will happen? NO.
Can you predict how bad the recession will be? NO.
BUT, can you reasonably assume there will be one? YES.
Now, why are we writing this piece? Doesn't it seem obvious? Well, in fact, there are generally two schools of thought in personal finance and investing when it comes to recessions - neither of which are healthy for most people to adopt:
What's a better option? The better way is to simply observe things in light of historical data and without trying to quantify things. In this observation, you need to be incredibly humble of your lack of ability to really predict much but you still need to be mindful of the length of bull market runs. As the run gets longer - as Year 1 turns into Year 5 and then turns into Year 8 of a bull market you will want to
Most people will sell during a recession - usually after having purchased at the previous highs in a euphoric frenzy. You, however, should be sitting calmly with a pile of cash ready to buy excellent stocks at very low prices. In the meantime, you'll still want to be investing - you don't want to stop investing and wait for a recession because you can't rally predict when it will come and you don't want to spend years sitting around waiting without getting any market returns.
Be wary of those individuals who try to predict things too much, in fact, add a lot of risk to the equality. The risk comes from the false assurance they provide themselves or others - it is better to wisely understand your total lack of knowledge about something than to confidently go forward when ou really don't understand something. As Mark Twain so eloquently stated: "It ain't what you don't know that kills you, it's what you know for sure that just ain't so."
Most people in history created their livelihood -- either by creating income or by actually producing the necessities of life with their own hand and toil -- within family or communal units. The idea of working at a job for a larger entity such as a corporation is extremely new in the grand swath of human history. In effect, almost all of the people who ever lived could in effect be classified as small business owners - this is even true today as most US employment comes still from sole proprietorships or small businesses.
Why is it useful to understand the history of work/labor?
This idea is very important to people living in modern societies because we have a view within our minds that is quite different from reality. Many people believe that:
Going beyond the present day and having at least a basic conception of the things our ancestors did to create substance and value in their ancient worlds will assist in opening up your mind to new opportunities, new ways of combining life with work, and new ways of creating value for others.
Hunting and Gathering - The First Sole Proprietorships
For most of our history, we hunted meat and gathered fruits and vegetables to feed our families and our very tight-knit communities. The lifestyle involved simply waking up with the sun, looking for food during the day, and resting in the evening. Bedtime was when it became dark and no hunter-gatherer had to plan very far ahead.
The first really interesting thing to think about when thinking about how hunter-gatherers provided for themselves is how there were almost never any intermediaries. Besides the possibility of occasional trade within tight-knit communities, hunter-gatherers had what can be considered a two-step method to getting what they wanted. In terms of purity of execution, this was the most basic/fundamental way of obtaining food and water - a hunter gather would literally expend energy in order to obtain the final product he/she sought.
The second interesting thing arises from the first - hunter-gatherers didn't create value for other human beings in order to achieve their goals. Of course, a hunter-gather might want to provide for his family and create value in that pursuit, but that's not what we mean here. What we mean is that hunter-gatherers either went to pick edible growings or killed animals in order to obtain sustenance. In that pursuit they did not serve any other human being in any way - they simply went out into the world and obtained what they needed from it. Contrast that with today's world where we almost exclusively have to earn our livings by creating value for other people, be they your employees or your customers (which are also your employers in a sense). We're not making a normative statement here - we're simply making a descriptive statement.
The third very interesting thing about thinking of the working hunter-gatherers performed is that they had a direct understanding of how their efforts and skills translated into the final product they obtained. Of course, hunter-gatherers likely had some sort of quasi-religious beliefs where they imbued objects, the weather, etc. with spiritualistic aspects and they might have relied on them to provide. However, that doesn't detract from the simple physics of hunting and gathering - every hunter-gatherer must have understood how it was their own physical efforts out in the world that were the proximate cause of their gain. They could have thought the ultimate cause came from the skies or from the tree spirits or elsewhere, but they surely understood that the proximate cause was their own effort - they surely understood that without themselves leaving their cave, picking growing, or killing an animal and dragging it home, their families would not have food to eat. Contrast that with today's modern corporate worker who works in a corporate office or campus and who has
These complex factors can include things such as
Yes, a person's well-being still depends on themselves and everyone must take responsibility for their lives - you must work hard and well so that you're able to do well in your job and in life. However, it is abundantly clear that the level of mental control that a person feels over his or her method of meeting wants/needs should have been far greater in the past than in today's complex and interconnected environment where so much of the economy is not visible or understandable by a single individual.
This understandability of relationship between soil and result could be psychologically beneficial to human beings on many levels. This isn't a psychology website and we're not purporting to have any theoretical or empirical underpinning for these statements, but it does seem to make sense that an individual who has a clear "a leads to b" understanding of the relationship between toil and result -- as opposed of "a to b to c to d to a BLACK BOX to e to f to g" understanding -- would have greater psychological comfort and less psychological stress.
In no way is above supposed to make you envy a hunter-gatherer - we live in a far richer world (both physically and mentally) than our ancestors and anyone who would want to give up today's peace, today's luxury, and today's comfort for a hungry dangerous life of basic subsistence and survival is a quite unusual person.
Agricultural Revolution and Farming
After many centuries of foraging, humans ended up farming. This happened gradually over the course of centuries as well, but the end result was the literal transformation of human life from a nomadic existence to a settled life that would be far more familiar to the modern person.
Although life transformed as well as the approach fro providing for it, humans still operated at a family or communal level - humans still remained in effect small business owners. The business changed, of course humans went from hunting and gathering to
Humans mainly operated as family units after the agricultural revolution according to current historical data with larger family-based communities existing for things that went beyond the family. In effect, each household ran a small farming business that employed the entire household from a relatively young age by today's standards.
Here people had a bit more complexity - their toil no longer immediately translated into value creation (eg. food to eat) but had to go through the intermediate step of waiting for the seeds to grow into plants. The same is true for livestock - farmers and heard had to wait for livestock to grow and spend time and energy on breeding instead of just going out into the wild to kill game.
We can see that from hunting and gathering to farming -- things which make up by far the vast majority of human existence -- we operated in very small-scale communities and were in effect creating our livelihoods within our family units. In effect, all hunter-gatherers and farmers until the Industrial Revolution turned farming into big business can be classified as small business owners in the very broad sense of the world. These individuals worked primarily for themselves and their families. Farmers in certain eras might have had to pay taxes to lords or barons or other elites, but these can be thought of as quasi-taxes. Almost all of humanity did not know the meaning of providing your labor (either in the form of physical or mental exertion) to another individual in return for some sort of payment - this was the case for many reasons, one of which was an economy that was so poor that it could not sustain such interactions in a meaningful way.
Artisans and Craftsmen - Sole Proprietors Throughout History
Beyond farming, there have been at times in history a class or artisans or craftsman. This class developed after the Agricultural Revolution as settled communities were needed in order for this class of people to arise. They mainly operated in larger cities and they ran what can be considered small businesses. The words "artisan" and "craftsman" is too narrow, however, as these individuals operated a large variety of business. These businesses including:
All of the above can also be classified as small businesses. They are more like the small businesses we think of today - instead of directly producing their own livelihoods, these artisans and craftsmen would set up shop and serve their communities. They would very likely have most of their family involved in the business and live either close by or directly above their shops.
The Modern Working World
Although the majority of US jobs still come from small businesses, most people think of work as something you do in a large-scale setting such as a corporation. Most people even aspire to such work.
This work is quite different than operating a small business because it involves providing your labor to a larger entity that you do not control and likely can never fully understand (not even the CEO of a large firm fully understand what's really going on). This creates a sort of "black box" effect where you provide your labor into a "black box" and then some income is given to you. You aren't totally sure about the actual value you're creating for the firm and you don't fully understand how your labor fits into the bigger puzzle.
There are of course many benefits working in jobs - most of these benefits come from a certain stability that is not always present in running a small business. However, there might be some psychological costs that affect a person in the following ways:
Working in a job might make a person blind to other small but very profitable opportunities where their skills might be used. They might not ever consider opening their own business, running their own website, consulting on their own, or providing value on a small scale. This is unfortunate because it is in such small setting where you are able to capture the full value of your efforts (instead of the employer capturing most of the value). This is really how people get rich today - most people will never get rich working for a job and saving a large portion of their income; the vast majority of people in our world get rich in entrepreneurial activities.
Some Examples of Employment Throughout History
Although most people worked for themselves throughout history, there were some interesting examples of employment throughout history. Here are a few:
You can't predict when a recession will hit, but you can be sure that a recession will come at some point. Speculation on the exact timing is a fool's proposition, but indicators exist to indicate when the overall market is overvalued and when a recession is more likely. Preparation for a recession is wise and simply ignoring overall market valuations will cause you to (1) not be ready to take advantage of investing opportunities a recession presents and (2) be potentially exposed in troubling ways due to improper diversification. The below 3 strategies are excellent ways to prepare for a recession.
1. Start Piling Away Cash for Cheap Stock Purchases When the Recession Hits
Cash is dry powder to investors and without some set aside you simply won't be able to take advantage of a recession. Cash will allow you to buy good stocks at deep discounts when the market falls during a recession.
Do you notice how the first thing we're advocating in terms of recession preparation is something that will allow you to buy more stocks instead of something that is meant to protect you? Obviously, you want to be protected in severely adverse market circumstances as an investor, but the most important thing about a recession isn't what it does to your portfolio in the short term, but the potential it has to boost your portfolio in the long term. A recession allows you to buy a lot of good quality companies at deep discounts - sometimes you see a price to earnings (P/E) ratios of indices such as the S&P 500 can drop below 10, indicating an extremely undervalued market overall.
Without having cash piled up ready to toss into good companies -- it's key that you only buy good companies -- you will miss out on potentially outsized gains due to inevitable market recoveries. The great thing about recessions is that you don't even have to pick individual stocks - something that is not recommended for novice investors or those with low-risk tolerances. Purchasing indexes (eg. S&P 500 or the Dow Jones) via broad mutual funds or ETFs will allow you to at once diversify and benefit from future recoveries. Purchasing the Dow Jones at the bottom of the 2007/2008 Great Recession would have created a 300% + return over the course of a decade without having to take on the risks of owning single stocks or having to put in the effort to pick them.
When the market seems overvalued in terms of market P/E ratios, in terms of timeframe since the last recession, or in terms of high-quality research/opinions, it might be a good idea to slightly pull back on some of the more speculative investing you're doing to put aside cash. You'll want enough cash so that you can comfortably enter positions at lows and then continue buying more and more if markets continue to drop. This abundance of cash will allow you not to think about timing the market -- something that you will not be able to do -- but will instead allow for an aggressive dollar cost averaging strategy once things start to decline until things start to turn up again.
2. Properly Diversify Your Portfolio so it Can Withstand a Recession
To make your portfolio more resilient to recession declines you'll want to diversify across:
You don't want to hold just US firm and you don't want to hold firms only in a single industry (eg. tech). Instead, you want to hold a broad portfolio of high-quality firms from around the world and from different industries. Some regions and industries will be more resilient than others and this will affect your portfolio. additionally, some firms will go bankrupt in recessions - hopefully, you don't own any such firms because you've done proper due diligence but some things are very hard to predict. You'll want to not be tied to a single industry, a single location, or a single firm when the market turns downward so that a single disastrous event will not affect more than a small portion of your portfolio and so that you can survive as an investor into the recovery.
A great way to diversify is through the use of mutual funds and ETFs, but diversification is also achievable through simply building your own high-quality stock for experienced investors - moderately experienced investors should not try this (novice investors shouldn't even think about this).
3. Buy Protective Puts on the Market (ONLY FOR ADVANCED INVESTORS)
If you don't know what a protective put is, this section is not for you at all and you should skip tot he end of the article.
If you do know what a protective put is but wouldn't be properly considered an advanced or experienced investor, you can read this section but you should not engage in this activity because it could cause a needless drain on your portfolio and a false sense of security.
If you're an advanced investor, you probably already know this strategy, but we'll remind you again. Protective puts are simply put options - they are called protective because of the context they are being used in. You can buy such protective puts on the overall market via market proxy (eg. S&P 500) in order to profit from market declines.
One way to execute such as strategy is to buy monthly out-of-the-money puts on the market proxy via a mutual fund or more likely an ETF. These should be out-of-the-money because what you're buying here is a form of insurance in case the market drops significantly - you're not trying to speculate. Out-of-the-money puts will be worthless if the market goes up or doesn't move much but will increase in value in a significant market decline. You can buy them for a reasonable term - monthly, quarterly, yearly but shorter repetitive purchases might be better because you're less exposed to the option's time decay.
If you're invested in the stock market -- be it with an individual portfolio, through an IRA, through a robot-advisor, or through a 401k -- you should know that markets will decline, economies will suffer, and your portfolio value will decrease. You can try to create a situation for yourself where you won't be exposed to the volatility of the markets, but the only real way to do this is to not be invested in equities at all - by entering the markets you're implicitly accepting a certain amount of short-term volatility that could cause you to see your portfolio drop by quite a bit. It's how you handle this drop that determines your resiliency as an investor and, in the long-run, that determines whether or not you're a successful investor.
Recessions Will Occur and Markets Will Decline
First, it's key that you understand that market will decline - you can't hide from this unless you're not invested in equities. If you only hold cash or fixed income securities (eg. bonds), you can safely ignore market prices on equities. In the case of cash, you don't care about the market either way. In the case of bonds -- although bonds can of course rise and fall in value based on credit worthiness and interest rates -you generally are more concerned with the ability of the borrower (eg. sovereign government, municipality, or firm) to pay as the agreed-upon schedule. If you hold stocks, however, you are exposed to two key factors:
Exiting the Stock Market at a Macroeconomic Downturn is One of the Greatest Mistakes an Investor Can Make
Imagine you own your house outright in 2007 and then in 2008 through 2010 the housing market starts to decline as it did in the US. Would you sell your paid-for house after seeing a drop in real estate prices of 30% or more? Clearly, that would be idiotic if you didn't need the money for something specific. Why, then, do so many investors feel so inclined to sell their stocks after a market drop? Just as with a paid-for house, you own your stocks outright unless you bought them on margin (highly unlikely for most retail investors).
Adding a mortgage on the house makes the situation riskier and it is, therefore, more understandable that you might need to sell your house in an economic downturn (eg. income loss). However, people are still far more inclined to sell losing stock positions in a macroeconomic downturn than they are to sell their mortgaged house. This doesn't make any rational sense and it represents a fundamental flaw in the way most people approach their portfolios.
Now, if something fundamental changes - meaning one of the following:
THEN you can be justified in existing a position. In this case, you'll be exiting, not because of a macroeconomic decline, but because of a macroeconomic change to your world of the stock you're holding.
In other circumstances, however, existing a previously good position is just foolish and will lead you to underperform the market over the long term. Additionally, you'll be effectively shooting yourself in the foot - you will be purposely selling off at the worst possible time instead of holding out a bit for a far better market scenario where a more fair value can be obtained for your investing.
Play Mind Games With Yourself to Prepare for the Inevitable Market Decline
One of the greatest ways to prepare for the inevitable market collapse (if you still think that this won't happen you need to go back and diligently study investing history before you proceed any further into the markets) is not use the same tactic elite athletes use to prepare themselves for competition - mental visualizations of game day with a focus on the desired outcome and the challenges that will likely be faced.
Elite athletes focus on the win, but they also visualize and understand the pain and the suffering that game day will likely entail. Instead of being optimistically naive, they in advance fully understand how difficult game day will be, they accept that difficulty fully, and they commit to persevering in spite of it.
Applying that same theory to your investing life you might want to visualise the goals you want to achieve (eg. the return you want to obtain over time or the number you want to hit in your portfolio) but you also will want to sit down and imagine how a 10% market drop will feel, how a 25% market drop will feel, and how a 50% market drop will feel.
Typically a 10% market decline will occur once every couple of years, a 25% market decline will occur once every decade or two, and a 50% market decline will occur up to a few times in your investing life. Failing to prepare for this almost inevitable circumstance could cause you to sell at a 50% market drop - clearly a very unpleasant outcome if waiting just a few years would allow you to recover all of your gains as has been shown via a study of US stock market history.
When you're playing these mind games with yourself it's key to really visualize the scenario and get that negative feeling in your gut you would get on the morning fo the crash. You will likely not have as intense emotions as you would actually staring at your dropped portfolio, but you should definitely feel that nasty feeling in your stomach. If no feeling accompanies this exercise you're doing it wrong and you should continue doing it over time until you really get that unpleasant gut feeling.
Once you have that gut feeling, let it wash over you and don't try to make it go away as humans tend to do with all emotions. Let the feelings stay with you and explore it a bit. See what that feeling is telling you to do. Realize how your emotions are ruling over you instead of anything rational - this is dangerous because investing is very unnatural to human beings and only rationality will help you do well. Tell yourself
It's important to not underestimate the power of such mental exercises. It's easy to dismiss this and argues that imagining things during a bull market won't help you when things really go bad and you actually are sitting in front of your broker's website looking at a number that is 50% less than it was yesterday. Of course, the two things aren't the same, but the power of visualizing is far greater than meets the eye at first. A lot of mental resilience to making foolish moves can be built up using the exercise above and be doing it once a quarter will over time create a healthy mental discipline against acting like a crazy person when things really go bad int he stock market.
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