Recessions and what they mean for investors

Recessions are the most anticipated economic events and among the least useful things to position a portfolio around.

What a recession is

Definitions vary.

A common shorthand is two consecutive quarters of falling output, which is simple and not what official bodies use.

Official determinations in several countries consider a broader set of indicators — output, employment, income, spending — and are made retrospectively, sometimes many months after the recession began.

Which means that by the time a recession is confirmed, it is frequently over or well advanced.

The timing problem

Why positioning fails.

Markets are forward-looking and tend to fall before a recession is apparent and to recover before it ends.

Which means the market bottom typically occurs while economic news is still deteriorating, and the recovery begins while unemployment is still rising.

An investor waiting for economic conditions to improve before returning to the market therefore misses a substantial part of the recovery.

And an investor selling when a recession is announced is frequently selling after the market has already fallen.

The forecasting record

Which is poor.

Studies of professional forecasters have consistently found that recessions are rarely predicted in advance, particularly turning points, which is precisely when a forecast would be valuable.

The yield curve inversion signal has a reasonable historical record in some economies with a variable and sometimes long lag, and has produced false signals.

Which means it is an indicator worth knowing about and not a timing tool.

And the frequency with which recessions are predicted vastly exceeds the frequency with which they occur.

What actually happens to markets

The historical pattern, with wide variation.

Equity markets have typically fallen in advance of and during recessions, with the magnitude varying enormously.

Recoveries have typically begun before the recession ended.

Government bonds of high-quality issuers have frequently performed well as rates fell — with the important exception of inflationary recessions, where both fell together.

Defensive sectors have typically fallen less.

And the dispersion between episodes is large enough that using the average as a guide is unreliable.

What matters more than the market

For an individual.

Employment: recessions produce job losses, and the personal financial consequence of losing an income generally dwarfs the portfolio effect.

Which means recession preparation for most households is about income security and cash reserves rather than about portfolio positioning.

Specifically: an emergency fund, understanding sick pay and redundancy entitlements, avoiding excessive fixed commitments, maintaining employability, and reducing high-cost debt.

These are considerably more valuable than any tactical asset allocation change.

What not to do

The common errors.

Selling in anticipation, which requires being right twice.

Stopping regular contributions, which forfeits the benefit of buying at lower prices.

Abandoning a long-term allocation based on a forecast.

Moving entirely to cash and waiting for clarity, which does not arrive in an identifiable form.

And taking on leverage in anticipation of a recovery.

What to do instead

Practical.

Ensure short-term money is in cash and untouched.

Continue contributions.

Rebalance according to the rule, which mechanically buys what has fallen.

Check that the allocation still matches your capacity for loss, which may have changed if your job security has.

Review fixed costs and debt, which is where household resilience actually sits.

And reduce consumption of financial news, which during downturns is optimised for engagement rather than for your outcomes.

The reframe for accumulators

Worth stating.

An investor with decades of contributions ahead benefits from lower prices, since future contributions buy more.

Which means a recession early in an investing life is, arithmetically, favourable — provided contributions continue and the person remains employed.

That last condition is why employment and cash reserves matter more than portfolio positioning.

The reframe for those drawing

Where the position is different.

Someone withdrawing from a portfolio during a decline faces sequence risk, which is discussed elsewhere on this site.

The mitigations — a cash buffer covering a year or more of withdrawals, flexible spending, and guaranteed income covering essentials — are what protect against this.

And they should be in place before a recession rather than assembled during one.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.