We have all seen, and felt, what’s happened in the U.S. stock market over the past year as we spiraled further into a recession. With the market down over 40% we’re wondering how our portfolios can survive and where we should (or shouldn’t) be investing our money. When the U.S. stock market is experiencing sharp losses, the first place to look for safety is international stocks. Unfortunately, you won’t find much help there today. In fact, the losses overseas are actually worse than here in the U.S. For example, the stock markets of Russia and India fell 72% and 65% in 2008—making us feel lucky to have only lost 40%. Seeing these poor returns and reading negative headlines convinces most investors they should sell their stocks and go straight to cash. This is a mistake you don’t want to make.
Disciplined investors know it would be premature to convert to cash without first considering all the investment options available to them. After considering U.S.and international stocks, the next investments to look at on the “depth chart” are corporate bonds. Struggling companies that want to stay in business during a recession raise money by selling their bonds to the public. To entice investors to buy these bonds, corporations offer high interest rates. But the high rates are accompanied by high risk. For example, in November of 2008 you could have purchased a 5-year Home Depot corporate bond that pays 9% interest per year! That’s a tremendous return for a bond, but there’s a reason it’s so high – it’s very risky. What if Home Depot (or another company whose bond you purchased) goes out of business before the bond matures? You will lose your investment. Unlike a stock, you can’t sell a bond anytime you want, which means even if you see a company struggling there’s little you can do. If the bond defaults before the maturity date, it’s very likely you’ll lose your money.
If corporate bonds are too risky, smart investors next look to government investments like Treasury bills and Treasury bonds. The problem is that everyone is turning to government investments because they’re considered the only safe investment left. When so many investors turn to government investments the interest rates suffer. In fact, the interest rates have dropped so much that they’re negative for short term Treasury bills. This means that instead of receiving interest, you actually have to pay interest.
The last place left to turn is cash. But if you sell your investments and go to cash today you will be locking in investment losses that up until now have been mostly felt on paper. Also, the effects of inflation and taxes will increase your loss if you convert too cash today.
This makes the decision of where to invest even more difficult because it seems like there’s nowhere to turn. On the one hand, we know the US and international stock markets have given us significant losses that could continue for weeks, months, or years to come. On the other hand, if we convert to cash we’ll be locking in losses and being more reactive than proactive. You’ve heard the saying that investors should “buy low and sell high”, but if you switch to cash today you’ll be doing just the opposite. The answer to the question, “Where to invest in today’s recession?” becomes a balancing act, with some US, international and cash exposure needed to add the most value to your portfolio. What proportion of these you should have in your portfolio depends on your risk tolerance and time frame. The allocation you choose should be designed to soften the blow of future losses while keeping you in position to take advantage of the stock market rebound when it occurs, which it will. A possible allocation may be 50% in the US stock market, 25% in the international stock market and 25% in cash (a much higher cash position than usual due to the fact we’re in a recession).
If you’re looking for additional opportunities to recession-proof your portfolio then consider investing in corporate bond funds and REITs. You should also give extra thought to paying off your debt early. But you shouldn’t choose any of these options until you fully understand the risks involved.
1. Corporate bond funds. A single corporate bond is too risky by itself due to high default risk, but a corporate bond fund decreases this risk substantially. A corporate bond fund is a collection of hundreds of corporate bonds. By pooling all these bonds together the effect of a single company defaulting is significantly reduced. Consider what happens if you own one corporate bond and that company fails? What would happen if that same company fails but it’s one of over 500 corporate bonds you own?
2. REITS (Real Estate Investment Trusts). Yes, real estate has performed poorly and the housing market may not have hit bottom yet. But REITs pool together many different real estate investments and currently pay high dividends. Also, REITS have a low correlation with the stock market which is a great advantage in a recession. A “low correlation” means that REITs will not necessarily go down just because the stock market falls on a particular day (the reverse is also true).
3. Pay off debt early. The third, and safest choice of the three, is paying off your debt early. Even if you have a low interest rate of 5%, you may want to consider making double payments to retire your debt early because you won’t find that rate of return in the stock market today. But when you use your investment dollars to pay off debt early you’ll no longer have it available to take advantage of the stock market rebound when it occurs.