A strategy for investing during a recession

There is a difference between investing during a recession and investing in anticipation of a recession. When a recession is already underway, the options are limited. The best options are things you can do in anticipation of a recession. The very best options are those you can undertake to prepare your portfolio to ride out challenging economic environments of all kinds, recognizing that a recession is an event that can occur at any time. Here are some strategic suggestions, including both dos and don’ts.

Suggestion 1: Don’t panic and sell

Panic selling almost always turns out to be wrong. If you own well-chosen stocks, a recession and bear market aren’t the end of the world. Your portfolio will eventually come back. And who knows? If it does turn out to be the end of the world, there’s not much you can do about it. Eat all the ice cream with chocolate sauce you want, I suppose.

Panicking can be bad for your health. Instead, try working out, reading a book or embracing stoicism. It’s not so much what happens to you as how you deal with it. Detaching yourself from what is going on around you is the first principle of successful investing.

Suggestion 2: Do nothing at all

Don’t do anything, just sit there. Try to not look at your portfolio for a while. This is the John Bogle approach, suggesting that you establish a proper mix of an index stock fund or exchange-traded funds (ETFs) combined with an index bond fund or ETF. As the founder of Vanguard and the first to popularized index funds, Bogle would naturally prefer the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total Bond Market ETF. Both have minuscule expense ratios (.02% and .03%) and include everything in proportional weights, which provides natural diversification. You don’t attempt to outsmart the market by focusing on a particular sector at a particular time.

The John Bogle approach is hard to beat for individuals who don’t spend a lot of time studying the market. Those who have followed Bogle have done well. Although I subscribe to the approach of doing little or nothing, index investing hasn’t been my personal approach. The S&P 500 or VTI has the virtue of automatically increasing your exposure to the best growth stocks as they grow to be an ever larger portions of the index (adjusted daily). There is also the downside of periods, such as the past two years, when high flyers come back to earth and drag down the index. My own portfolio consists of individual stocks put together in a way that seeks to avoid that extra volatility.

It’s not necessary to beat the index to do very well and achieve your personal goals. One goal of a stock portfolio is to avoid catastrophes by staying away from high-risk stocks. The indexes are required to own them. You don’t have to. A sensible goal is to beat the index in risk-adjusted terms. Most of the stocks I own are low beta and are selected to perform well enough in a variety of environments, including inflation, deflation and recession. I have also bought I bonds regularly since 2000. Most purchases came when inflation wasn’t a major issue, but they have recently served very well as an insurance policy against inflation.

Remember that the most important actions dealing with a recession are taken before the recession begins. Being prepared is always the way to go. Don’t let yourself go into a recession with an undiversified portfolio full of risk. When I was a financial advisor, the saddest thing I ever thought was, “The solution to your problem is to have not gotten yourself into that position in the first place.”

Suggestion 3: Don’t chase individual sectors unless you are a skilled trader

It doesn’t make much sense to me to make long-term buys on the basis of your expectations for short-term outperformance. Even if you manage to get it right, what do you do when the cycle moves on to the next stage? My preference is to own a mixture of quality stocks, which as a group will provide good returns over the long run. I realize many analysts emphasize particular sectors for various market stages, both on Wall Street and Seeking Alpha. The focus is often on sectors with high dividends. Owning some stocks that pay good dividends is fine. Among other things, it reduces the duration of your equity portfolio because high dividends accelerate return of your capital. They may also go down less than the market in the early stage of recessions.

Two examples of such holdings in my portfolio are Johnson & Johnson and McKesson Corp. Both are good companies in the health care area, which are largely uncorrelated to the rest of my portfolio. It’s important for you to know I bought them when no recession was on the horizon. Two other areas that protect in recessions are insurance, where I own Travelers Companies, Inc., and Markel Corp., as well as aerospace/defense, where I own Raytheon Technologies Corp. I might also add Lockheed Martin Corp., if it becomes cheaper in the course of a further market decline. Both insurance and aerospace/defense have customers who will not reduce their spending because of a recession. I knew that when I bought them, but it was not the only reason I bought them. I had no expectation of nailing the timing of a recession, they are simply part of a diversified portfolio.

Suggestion 4: Take advantage of opportunities in fixed income

In an economic contraction, bonds rally first, then stocks and then commodities. In an economic expansion, bonds decline first, then stocks and then commodities. As I said in the third suggestion, trying to time stock sector buying occasionally works for skilled traders but is not a sound policy for long-term investors. The same holds for commodity stocks — the closest most investors come to actual commodities. Most are too cyclical.

Think of fixed income (i.e., bonds) as an asset class that extends all the way out from cash in money market funds to maturities of 30 years. The thing you can sometimes do in a timely fashion is shorten or lengthen maturities.

The current situation is ambiguous. The Federal Reserve is committed to increasing rates sharply; meanwhile, the behavior of many rates and other indicators point toward a recession, which might move the Federal Reserve to reverse its position and cause rates to fall. My solution was to move half of my cash reserve to a short-term Treasury ladder starting at six months, with steps of every six months out to two years. This plus the 50% still in cash produces a Treasury average rate of over 3%. Longer Treasuries offer little if anything more. It also maintains the flexibility for adding to the ladder if the Federal Reserve keeps increasing rates. On the other hand, you can buy and lock in longer Treasuries if it becomes clear that the Federal Reserve is about to lower rates to fight the recession. You can also use cash at that time to buy stocks, which have the longest duration of any financial asset. This nuanced strategy using Treasuries is the only thing I see that can take advantage of market cycles and economic cycles.

Suggestion 5: Take advantage of tax losses

Over the years, I have taken every opportunity to sell stock positions that are in the red. This is one of the advantages of having a stock portfolio instead of owning stocks through an index. If I have a stock or a tranche of a stock position that is in the red, I generally sell it toward the end of the year. Most of the time, I have been able to buy it back after 31 days without paying more. I do try to time my tax loss sales so as not to be doing it at the same time everybody else is.

The beauty of this strategy is that it makes your losses work for you. If you have a stock you are hesitant to trim because of embedded capital gains, a tax loss can be used to offset the gains. If you have no gains to offset, you can use up to $3,000 to offset ordinary income. You can also keep a tax-loss bank indefinitely. In most recent years, I haven’t had much to sell for a tax loss because most portfolio positions have very long-term capital gains. However, this year, I did a quick sale of two small positions that I had been too early to buy. I’ll buy them back in good time.

Bear markets frequently provide opportunities for tax-loss selling. People don’t like to sell losers and are often too quick to take profits. This turns the best strategy upside down. Another market adage is: “Sell your losers and let your winners ride.” Many of my winners have been riding for over a decade. Along with keeping your expenses down, taking tax losses is one of the few freebies in investing.