What Does a Recession Mean to Your Investments?

What Does a Recession Mean to Your Investments?
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With the Federal Reserve raising interest rates and inflation continuing to rise, many Americans feel concerned the next recession is coming. Since the slowdown from a recession can affect everything from unemployment rates to short-term interest rates, you can experience lower performance or losses in your investments. The extent of a recession’s effects will vary by the type of asset as well as the level of risk the investment has in general. Taking a look at how a recession can affect different asset classes can provide insight into how to recession-proof your investments.

Read More​: Investing During Inflation

What Does an Economic Downturn Involve?

A recession is a contraction of the gross domestic product (GDP) lasting at least two quarters and is a natural part of the economic cycle. It can occur due to various causes such as crises like a pandemic or war, too much credit expansion, high interest rates, a slowdown in major markets and deregulation.

As a result, people feel less confidence in the economy, unemployment can rise as company performance worsens, interest rates decline at least for the short term and it becomes harder to get credit. The Fed takes action to try to stimulate the economy in such a situation and help prevent a recession from turning into a depression.

Falling interest rates and reduced company performance particularly contribute to your investments’ performance during a recession. For those investments that pay you interest, you’re at a disadvantage if the rate is variable and drops due to poor economic conditions. Other investments based on market performance can experience significant losses during a recession as organizations cut costs and experience less demand from customers.

Dividend and Growth Stocks

If you’re still quite far from retirement age or have a higher risk tolerance, you might have a significant portion of your investment portfolio in stocks. As long as you choose good-quality stocks, you can earn a higher return than with alternative products such as annuities, bonds and money market funds. However, they’re risky during a recession when companies’ financial performance is struggling and stock prices tend to fall. For example, during the recession in 2008, the S&P 500 annual return on investment (ROI) was ​-36.55 percent​.

The volatility and risk can depend on the type of stock, however. Dividend stocks, for example, are considered safer since you get a periodic dividend – although it may be lower in a recession – alongside experiencing any changes to the stock’s value. Growth stocks, on the other hand, come with more risk since you’re relying entirely on positive changes to the stock’s value to grow your investment. The riskier your growth stock is, the higher your potential loss is during a recession.

he extent of a recession’s effects will vary by the type of asset as well as the level of risk the investment has in general.

Stock performance during a recession can highly vary depending on the company’s industry too. For example, if you’ve bought stock in companies providing essential services such as transportation, healthcare and the sale of consumer staples, this can lower your risk. However, stocks from companies in more recession-sensitive industries such as hospitality, oil and gas, entertainment and restaurant dining come with more risks and a higher potential for loss.

Government and Corporate Bonds

Compared to investing in the stock market, having bonds leads to less risk during a recession since they often pay fixed rates and experience less volatility. For example, Treasury bonds had a ​20.10 percentannual ROI in 2008 during the recession, while medium-grade corporate bonds had a ​-5.07 percent​ ROI. In these cases, bonds performed much better than the ​-36.55 percent​ ROI for S&P 500 stocks. However, the quality of your bonds matters as well as the possibility you have some with variable rates.

For example, you can expect your Treasury bonds to be safe during a recession since the U.S. government has never defaulted on them. However, corporate bonds present more risk that the company could default due to hardships during a recession, and that would mean you could stop getting interest paid or lose the principal itself. High-yield corporate bonds are particularly susceptible.

Mutual Funds and Exchange-Traded Funds

If you have exchange-traded funds (ETFs) or mutual funds, you’re essentially investing in a collection of bonds and/or stocks and reducing some of the risks of volatility. If a recession causes specific companies to perform poorly, you’ll usually be somewhat better off thanks to the diversity these investments offer. However, the overall performance will depend on the specific bonds and stocks and the factors discussed for each type of investment.

An example of a particularly low-risk mutual fund during a recession is the money market fund. It consists of short-term debt investments, but there’s often a low return. On the other hand, index funds can be ETFs or mutual funds but come with more risk during a recession since they’re based on the S&P 500 stock market index. If the companies on that index don’t do well, then you can lose more money with index funds.

Bank Account Products

Regular savings accounts, certificates of deposits (CDs) and money market checking accounts are safe investments in general, although the interest rates are usually low. This especially holds true when the credit union or bank is covered by federal deposit insurance. Therefore, they’re a good option for investing when you have a low risk tolerance, such as when you’re putting aside money for an emergency fund.

But while you likely won’t lose your deposit during a recession, you could see your interest rate drop. While traditional CDs have a fixed interest rate that wouldn’t drop during a downturn, others have variable rates that can fall. Regular savings and money market accounts usually also have variable rates, so the effects of a recession can hurt your money’s growth.

Other Investment Types

A recession can affect other types of investments as well. That means it’s a good idea to speak with a financial advisor about your specific situation.

For example, if you’ve bought annuities to help provide you with reliable retirement income, you could end up with a lower payout if the annuity is variable or indexed. This would happen since the return will be based on market performance.

In addition, if you own a home or other real estate, a recession can cause the value to fall for your investment. For example, real estate experienced a ​-12 percent​ annual ROI in 2008 during the recession. This can be an issue if you need to sell your real estate and don't have time to wait for property values to rise again.

Making Investment Decisions

If you’re looking into changing your investment strategy ahead of a recession, you’ll want to keep diversification, your risk tolerance level and your time horizon in mind as you make decisions.

For example, if you’ve got a few decades before retirement and have an asset allocation mostly of stocks, this is riskier even without a recession. But at the same time, you have more time to recover from the investment-related effects of a recession or market downturns in general. On the other hand, if you’re near retirement, moving toward lower-risk options like bonds and mutual funds can offer less risk during a recession since you'll want to focus on keeping the money you already have.

In any case, consider the quality of your investments and avoid making short-term decisions that can hurt you in the long term. For example, going with only low-risk investments can mean you don’t earn enough over time to meet your retirement savings goal.