4 Ways to Hedge Your Portfolio Against a Recession
Summary: There are several ways you can potentially hedge your risk when investing during a recession. Learn what they are and how to use them.
While they can be painful, recessions are an unavoidable part of the economic landscape. If you’re used to building your savings in a bull market, investing in a recession may require you to adjust your strategy and hedge risk to help reach your financial goals.
First, what is a recession?
A recession is a sustained period of negative economic growth that can lead to layoffs, decreases in corporate earnings, and dwindling consumer confidence. As a result, investors may experience more market volatility, and may struggle to achieve the returns they would like on their investments. Keep in mind that markets tend to price in recessions ahead of time, so once there is an official declaration of the recession the market may have already bottomed.
In a market downturn, investors facing uncertainty may want to hedge their investments to help safeguard their portfolio and possibly emerge stronger when the market recovers. While there is no such thing as a recession-proof portfolio, adopting an effective hedging strategy can help you reduce your risk. Let’s look at four hedge strategies to consider when facing a potential economic recession.
#1: Take the long view
While a recession can make investors nervous, most do not want to pull your money completely out of the market. Panic selling typically only locks in your losses, while staying in cash too long means you may miss the potential upswing as the market recovers. By staying invested throughout a recession, your portfolio may be more likely to recover as the market does.
This doesn’t mean you need to hold on to each and every existing investment. Instead, consider rebalancing your portfolio to reflect your risk tolerance in the current economic and market environment.
#2: Diversify your portfolio to help reduce risk
In a bull market, it’s tempting to build a portfolio that is heavy on hot stocks. And in a bear market, it may be equally tempting to sell declining stocks or other asset classes. While it can be a bad time to sell, a market drawdown is a good time to assess your risk tolerance.
Instead of cashing out completely, consider if you should reallocate, rebalance and diversify your portfolio to reflect the new reality of the market. Use this opportunity to revisit your portfolio’s asset allocation–or the desired mix of stocks, bonds and cash–to see if you need to rebalance your holdings based on how much risk you’re willing to take. If you find that you’re too heavily invested in a particular asset, such as a risky stock or fund, consider trimming your exposure and reinvesting that money elsewhere.
Whether you choose to sell some of your current holdings and reinvest the proceeds or have additional funds you’d like to invest, here are a few ways to diversify your holdings:
- Consider moving some of your portfolio into cash and cash equivalents that can help you preserve capital in a volatile market while generating a steady income. These include high-yield savings accounts, certificates of deposit (CDs), money market funds and ultra-short bond funds.
- Invest in companies with a strong track record of paying dividends. The potential benefit of dividend-paying stocks is that they can generate income even if the stock price falls, which can potentially reduce your exposure to market volatility.
- Look for opportunities to play defense by investing in recession-resistant, or “defensive,” companies or sectors, such as consumer staples and utilities. Because they are necessities in good times and bad, these companies often continue to earn stable revenue regardless of how the economy is performing.
- A recession in the U.S. doesn’t necessarily mean a global downturn. An internationally-diversified portfolio can potentially help smooth out your returns over time. Consider investment opportunities in international heavyweights and emerging economies. Keep in mind that investing overseas may come with its own risks.
- Explore hedging with gold to diversify your portfolio with an asset that historically has a low correlation with stock market performance. As with any investment, consider your risk tolerance before investing in gold.
#3: Outsource your decision-making
Maintaining your portfolio during a recession can be a daunting task. If you feel overwhelmed or just want to hand it off to a professional, you can leverage certain investment vehicles, automated tools and outside help to build and manage your portfolio. Here are a few options:
- Balanced funds make it simple to diversify and rebalance your portfolio without any work on your part. These types of funds usually invest in a mix of stocks, bonds, and cash to help meet certain investment objectives, such as income generation or capital appreciation with a low or moderate level of risk. Once you find a fund aligned with your objective, you can invest in the fund instead of all its component parts.
- Core Portfolios— E*TRADE’s digital investing platform— combines professional investment advice with automated technology to take care of day-to-day investing for you. Your portfolio is customized to help provide optimal returns based on your goals and risk tolerance, and then is automatically monitored and rebalanced to help keep you on track.
- Prebuilt Portfolios from E*TRADE provide another way to diversify your holdings. These professionally built portfolios let you invest in a basket of leading mutual funds or ETFs without having to choose or manage each asset yourself.
- If you’re used to investing on your own, now might be the time to get a second opinion. A Morgan Stanley Financial Advisor can work with you to review your plan and make recommendations to help you stay on track.
#4: Consider liquid alternatives
Liquid alternatives, also known as liquid alts, are mutual funds or ETFs that may use certain non-traditional investment strategies to seek to generate risk-adjusted returns with lower volatility. By utilizing alternative-style strategies such as long-short equity, derivative income, relative value arbitrage and others, liquid alternatives may behave differently than the overall market, allowing them to potentially grow in value even as the market falls. In addition, their unique approach may give you another way to help diversify your portfolio beyond holding a mix of traditional investments like stocks and bonds.
The bottom line
Remember: Recessions are a fact of life. By staying invested and making thoughtful adjustments to your investment approach to reflect changing market conditions, you may be better positioned in the long run to meet your individual goals.
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