Developing an investment strategy that ignores the possibility of economic downturns is the equivalent of driving without insurance. You may pay a fee for the security of knowing you are covered in the event of an accident, but the alternative is driving under the assumption that nothing bad will happen. Similarly, investment strategies that seek to maximize return without providing for the possibility of a downturn expose you to unnecessary risk. This may sound like a crazy comparison, but some would argue that the only way to invest is with an eye to periodic economic downturns, just as the only way to drive is with insurance.
Precisely because it is not possible to predict when a downturn will occur or how long it will last, your investment strategy should assume that it is around the corner. There are several ways to achieve this goal, including the following;
1. Plan for the long-term
2. Know your time constraints
3. Employ dollar cost averaging
4. Diversify
5. Invest for value
6. Hold the course
7. Hire a Financial Advisor
Plan for the long-term
Markets are affected by natural disasters, political turmoil and interest rates among other things. It is therefore impossible to predict their performance on a short-term basis. The best you can do as an individual investor is to set realistic goals and then plan how you will achieve them. Which brings us to the next point…
Know your constraints
Your goals should be categorized according to their timelines. For instance, you may need to save for a house, stash some cash away for emergencies, provide for your children’s education and plan for retirement. Each of these goals is important, but they don’t all have the same time constraint. What this means is that each goal can take a different level of risk and so settle for a different return depending on how soon they need to be realized.
You may be thirty years away from retirement so you can afford to invest your retirement funds heavily in the stock market to maximize the return because you should, all things considered, be able to weather any possible economic storms over the time you have left. The money you are saving for your house though may need to be put into a different vehicle, such as bonds, because you may not have the time to rally through a downturn that could mean the difference between signing on the dotted line and continuing to rent.
Employ dollar cost averaging
The concept of dollar cost averaging involves investing a dollar amount at specific intervals, say five hundred dollars every month, in the stock market or an indexed fund. The idea is that when prices are low you get more for your money and when prices are higher you get less, but over time the average cost of your investment will be better than if you tried to time the market. This approach also encourages regular investing and helps you to get over the uncertainty in times of extreme volatility.
Diversify
If financial planners had to choose a mantra it would probably be centered on diversification. Diversifying reduces risk and volatility by spreading your funds across different asset classes. For instance, a single individual may have some money invested in the stock market, some in longer term bonds and some in money market accounts. To diversify even further you can drill down into each asset class and spread your money into different areas, so you may hold stocks in the energy sector, in the manufacturing sector and in the financial sector. This protects you in the event that one sector makes large losses, as only a portion of your portfolio would be affected. This strategy is important to investing with an eye on economic downturns, because it is hardly likely that all sectors of the economy will react in the same way. A gain in one area is often offset by a loss in another. The trick is to try to be positioned more often than not on the winning side.
Invest for value
If you know why you are buying into certain areas, you should have confidence in your decisions. It is important to invest for value and not speculate on future price swings. Warren Buffet is probably the best known proponent of this strategy. He buys into companies that have a solid business. These companies should have certain characteristics; a product that is in demand, a strong brand, consistent profits, low debt and relatively low operating expenses, to name a few. When you invest in solid companies you have a better chance of surviving economic downturns, because so do they. They may also lose value during troubling economic times but they will fair better on average than those that are poorly managed. Always remember that your investment is only as good as the underlying product or service.
Hold the course
When the economy takes a turn for the worse keeping a steady hand may be difficult, but it is important to be able to subdue anxiety and stay true to your plan. Of course there are instances when you should rebalance your portfolio. In cases where your time horizon is fast approaching it will be prudent to shift away from declining markets to avoid losses. By and large though you should not reverse your position unless your goal is approaching and you would not have the time to recover.
Hire a financial advisor.
If it seems like investing with an eye to periodic economic downturns is a full time job; that is because it is. Many people are unable to juggle all their financial balls at the same time and so they wisely turn them over to a professional financial advisor. You should of course be sure that you understand the basics and that you are comfortable with the course of action, but having the benefit of a financial planner gives an added assurance that you will get to where you want to be, economic downturn or not.