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.
Options are valuable - that's why you can literally pay for them when you purchase financial options (eg. put options or call options). Options are valuable because they allow you to decide in the future whether to do something or not to do it - you will decide at that future date based on what is going on at that future time. Although you can't know what the future will be like today, options allow you to postpone the decision (in a way) until you actually do know.
For example, when you buy a call option on stock X you are paying a premium for the right to decide in the future whether or not you want to buy stock X at the predetermined strike price. Effectively, you're paying a premium today to lock in the purchase price. You pay that premium (and so do millions of other market participants) because such a thing is inherently valuable. How valuable is it? That's a far more complicated question and beyond the scope of this article - the question of how to value a financial option is a complex one that involves complex mathematics.
Just like a financial options, options in life are valuable too - that's why you should attempt to increase the options in your life. You should attempt to make decisions with attention to the optionality inherent in them. If you have to choose between two different paths, be mindful of any inherent options that are imbedded in the choices. These inherent options can add real value to the decisions and they should be ignored.
Let's discuss one simple hypothetical example to better illustrate the point made above. Let's say you are choosing between two houses that are equal in every respect except...
Now, you might not want to rent out any rooms NOW, but House 1 has imbedded optionality that House 2 doesn't. Should you need the extra money, should your lifestyle change, or should rents go up a lot in your area, you might want to rent out a room or two in your house. House 1 allows you to EXERCISE that option should things unfold in a way to make it desirable to rent out a room or two. Just as you would exercise a financial option if the market price of the underlying is greater than the strike price, you can exercise this embedded option should it be worthwhile for you to do so.
Therefore, all else being equal, House 1 should be more valuable to you and to the market due to the inherent optionality embedded within it - an optionality that doesn't exist in House 2.
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