One of the most common reasons that people never get started investing is because they’re nervous about a recession or market crash. They assume that the day after they buy a stock the United States will plunge into the next Great Depression. They’re worried that their savings will be lost. So instead, they sit on the sidelines and miss out of years and years of potential growth.
While we would never tell you that a recession won’t happen, there are definitely things you can do to protect yourself. Here are a few of the ways that you can defend against a recession.
Don’t Bet The Ranch
“Don’t put all of your eggs in one basket.” “Asset Allocation is key.” “Diversify your risk.” Chances are you’ve heard advice similar to this at some point and there is a reason why: because it works.
Diversification is a common-sense practice and something incorporated by every professional money manager. Even if you don’t have millions of dollars to invest, you should still practice the same principles as professionals.
It would be a very risky move to start investing and to put your entire life savings into one stock, no matter how secure you think that stock might be.
There are two types of risk you come across when investing:
- Non-Diversifiable Risk (Market Risk) – Risk inherent in investing that cannot be minimized through diversifying or adding more investments. This includes things outside of your control (economic downturn, trade war, regular war, etc.)
- Diversifiable Risk – Risk that can be reduced through proper diversification of assets. Most research shows that a portfolio needs at least 20-30 stocks to properly reduce Diversifiable Risk.
Don’t feel like you need to personally find 20-30 stocks that you think are a good investment. Exchange-Traded Funds (ETFs) will take care of Diversifiable Risk for you. ETFs are just a collection of stocks that span an entire industry or asset class and we actually recommend keeping the bulk of your net worth in an ETF that spans the entire market.
Dollar Cost Averaging
One of the most common ways to protect your investments is to use a tactic called Dollar Cost Averaging. Dollar Cost Averaging is just a term for investing your money slowly over time instead of one upfront lump sum.
Let’s say that you have $10,000 to invest. Instead of investing the entire thing at once, you can invest that money gradually over time to protect yourself against fluctuations of the market. How slowly you want to invest it is up to you: it can be $1,000 every month, $100, or only $10. Doing this will limit your risk to market downturns. Let’s take a look at an example to see how it works…
Suppose you have $10,000 to invest and you invest it all in low-cost indexes that track the S&P 500. The next year the market drops 15% and your money is now worth $8,500. Over the next four years, the market increases 8% per year. By the end of 5 years, your money will be worth $11,564. Not terrible! But let’s see how Dollar Cost Averaging would’ve altered the results.
You still have $10,000 to invest but you decide to invest it in $1,000 increments each month until all the money is all invested. By the time the money is all invested (10 months), it will be worth $9,351. This is still assuming the 15% drop over the first year. Over the next four years, the market increases 8% per year. By the end of 5 years, your money is now worth $12,721.
With the same exact market conditions that’s roughly $1,187 more dollars made by the decision to invest your money slowly over time
UNDERSTAND: Dollar Cost Averaging is a great trick to protect yourself from market downturns. However, if there is no market downturn then it might mean your return won’t be as high than if you had just invested all at once. Decisions like this should be made on a personal level and are dependent on the amount of risk you’re comfortable taking.
Also remember that stocks are very liquid, which means that they can be bought and sold at a moment’s notice. This brings us to our next point which is…
Do NOT Panic
“The stock market is a vessel designed to transfer wealth from the patient to the impatient” -Warren Buffet
This is probably the hardest thing to do because it goes against your gut impulse. If the market starts to dip, aka recession, everyone’s knee-jerk reaction is to sell their investments and pull their money out. Selling and pulling money our during a downturn is probably the worst thing you can do because of two reasons.
- Most downturns are temporary and rarely turn into recessions. If it doesn’t turn into a recession then you’ve just sold your investments at a lower price.
- Downturns always recover. It may take a few months or even a few years but the market will always recover. Just look at the history of the market below in the graph below.
If you pull your money out while the market is at its lowest then you’re most likely wiping out any gains that you have made in the past and could even lose money. The last thing you want to do is buy high and sell low.
If you hang tight and keep your money in, the market will eventually recover and you will be back in business. This brings us to our third way to protect yourself against market downturns…
“Be fearful when others are greedy and greedy when others are fearful.” -Warren Buffet
Bear with us on this one. What happens on Black Friday every year in this country? People trample each other left and right to take advantage of great deals and savings.
Now, what if we applied this same concept to the stock market in recession? A market downturn is essentially just the stock market going on sale. Tons of securities are available to be bought at prices way lower than their value because everyone is panicking and trying to sell all at once. All you need is the emotional discipline and money on hand and you will be able to make a killing once the market eventually turns around.
To quote the words of legendary investor Warren Buffet again, “Be fearful when others are greedy, and greedy when others are fearful”. Or, when everyone is buying you should sell and when everyone is selling you should buy.
NOTE: This same theory applies to stock market bubbles as well. When it seems like everyone is buying more and more every day, time to start getting fearful.
Set Money Aside
We always recommend keeping some money on the side to give you peace of mind. The main purpose of this cash is to be ready in case of emergencies. If there is a market downturn and you are a little strapped for cash, now you’ll have a fund to pull from instead of selling investments. What most people will find is that there are hardly ever REAL emergencies where you need to use it but it’s still good to have.
In addition to simply having an emergency fund, most serious investors will keep some cash on hand waiting for market downturns. Warren Buffett keeps about 20% of his portfolio in cash so he can buy at a moment’s notice.
These are a few ways that you can protect yourself during a recession or market downturn. Something important to remember is that we recommend focusing on growing net worth over a long period of time. This means that you can take day-to-day fluctuations in the market with a grain of salt.