According to Anthony Watson, a CFP and founder and president of Thrive Retirement Specialists in Dearborn, Michigan, when planning for a future economic recession, portfolio diversification is essential. By choosing funds over individual equities, you can lower company-specific risk because you won’t necessarily notice a company going under among 4,000 other companies in an ETF.
He continued, “Many investors default to 100% domestic assets for stock allocations, despite the importance of international exposure. While the U.S. Federal Reserve is actively battling inflation, other central banks’ tactics could lead to different development trajectories.
How to Pick Stocks During a Recession
- Choose large reliably profitable companies
- Companies with sound balance sheets and healthy cash flows
- Companies facing large debt or declining product demand should be avoided
- Consumer staples tend to fare well during recessions as consumers need to purchase staples regardless of the economic situation
- Food, drinks, household items, alcohol, tobacco, and toiletries are examples of consumer staples.
In contrast, when individuals and businesses cut back on spending, the following may suffer:
- Appliance merchants
- Automakers
- Technology suppliers
Need for True Diversification
According to Forbes, publicly traded stocks have a high correlation. Some will always think it is wise to invest in them. The key takeaway is that your portfolio needs to have a wider range of investments. Whether you own 10 publicly traded equities or 110, you are still not protected.
The fact that most investors are not at all well-diversified poses the biggest threat currently. Many people think they are diversified because, on the advice of their broker or 401(k) plan administrator, they invested in a variety of stocks or funds. This isn’t true portfolio diversification.
Monitoring the relationship between the performance of your various investments is crucial. There may be a few outliers, but when the stock market crashes, pretty much everything collapses.
Correlation Ratios
The issue with publicly traded equities is that they move in unison due to their performance being highly connected. Most of them are performing favorably, headed in the same direction as they are going up. However, they also all fall together. That is a significant financial issue, and it always seems to surface when money is most needed.
Having a variety of investments and assets that won’t all suffer during these times is essential for creating a portfolio that is resistant to recessions. We talk about this in terms of correlation ratios in the investment world.
According to Forbes “These ratios are measured on a scale of +1 to -1. A correlation ratio of +1 means that two assets move in perfect positive correlation to each other, like public stocks. A correlation ratio of -1 means that they are synced and correlated in a negative way. They are opposites. Like a pair of scales, when one goes up, the other goes down. So when your stocks go down, this type of asset will go up in value.”
Furthermore, “A correlation of 0 means that there is zero correlation between two assets. Just because one goes down does not mean the other will predictably go up or down at the same time.”
Diversification
It is suggested to select 7 – 10 investments, each with differing correlation ratios. If you are investing only in the stock market then 5 – 7 diversified investments are advised.
- A minimum of 6 distinct investments and asset classes separate from anything in the public stock market.
- Look for assets that move inversely to the performance of your stocks or those with poor correlation to those fluctuations
Select investments with significantly less correlation. Examples of this are private equity investments, real estate, promissory notes, and debt investments. Gold has a negative correlation with the rupee and the stock market. It is a good option to diversify your portfolio.
Benefits of Diversification
- Compared to an undiversified portfolio, get higher returns for the same level of risk.
- achieve the same results as you would with an undiversified portfolio, more safely.
- Reduce portfolio fluctuations and volatility (lower standard deviation).
- Cut down on portfolio drawdowns (peak-to-trough losses during a crash).
Robert Johnson, professor of finance at Creighton University says “Traditionally a diversified portfolio was characterized as simply a portfolio with both stocks and bonds and the benchmark was a 60/40 mix of stocks and bonds [60% stocks],” says Johnson. “Today, many investors consider other alternative investments to be part of a diversified portfolio. These alternative investments include real estate, commodities, private equity, currencies and even cryptocurrencies.”
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FAQs
A portfolio is an assortment of financial investments such as stocks, bonds, commodities, cash, and cash equivalents, including closed-end funds and exchange traded funds (ETFs).
Spreading your investments among many asset classes limits your exposure to any one asset type. This is known as diversification. Over time, this technique should assist in lowering the volatility of your portfolio.
Appliance merchants, automakers, and technology suppliers
Large reliably profitable companies and consumer staples are a good bet.
