What are the different investment approaches an investor can take during an economic downturn?

First, let us get this clear. If you get caught into a financial tornedo unprepared, there is little chance you come out of it unharmed.

As we discussed in our previous article, ‘How to prepare for recession?’, the most successful investors are prepared for the possibility of sudden headwinds. This is because, when a sell-off kicks off, it is too late to act.

In this respect, holding a well-diversified portfolio is crucial.

Now, when we talk about an economic downturn, we talk about the risk that investors are ready and willing to take, and how much downside they can absorb. If you know your risk profile, then you can build the ideal portfolio for yourself.

The general rule of thumb is the higher the allocation to risky assets, the higher the portfolio returns — but also, the higher the amplitude of a single drawback during a market rout. In a similar way, the higher the allocation to safe assets, the lower the overall portfolio returns, but the softer the size of a potential single drawback.

Hence, the more aggressive a portfolio in term of its allocation to risk assets, the higher the risk of economic loss in times of market sell-off.

Therefore, the risk profile of an investor is the first and the most important hint about his or her approach to the market.

Each investor has an ideal level of risk he or she is ready to take. Hence an investor’s approach to the risk of an economic downturn depends heavily on his or her capacity to take risk.

A risk-averse approach involves an investment portfolio heavy in low risk assets, such as US treasury bills, gold, yen and Swiss franc. These assets tend to soften in times of flourishing markets. But when a sudden sell-off kicks in, they provide an efficient hedge to a portfolio.

A risk-taking approach, on the other hand, involves a solid allocation in equities and a diminished portion in safe-haven assets.

Equity investors can play with the level of risk they take by sector, and stock picking.

Growth stocks, as their name suggest, have the potential to grow faster in terms of revenues, cash flows or profits, and outperform the benchmark index. Value stocks, on the other hand, are companies whose share prices don’t reflect their value, therefore there is a potential for a price adjustment in term.

Growth stocks pay no dividends as investors mostly chase capital appreciation, while value stocks pay regular dividends. Dividends are a good source of revenue in times of an economic downturn, if companies decide to hold on to their dividends. In 2020 economic turmoil, many companies decided to slash dividends to keep cash to navigate through anemic market conditions. Some companies’ decision to reduce or cancel dividend payments were welcomed, others’ didn’t.

Growth stocks have high price-to-earnings (P/E), and price-to-book (P/B) ratios, meaning that their price is relatively higher than the value of their assets. Value stocks on the other hand have lower P/E and P/B ratios.

If you are a risk-tolerant investor, taking a growth approach could be more rewarding, but losses could be higher in terms of economic distress.

While you can’t predict a sudden downturn in financial markets, you can sometimes foresee periods of slower economic activity and act accordingly.

Some investors change their equity portfolio allocations based on economic data. Leading indicators, which include business surveys and sentiment indices, give an idea on what to expect in the foreseeable future.

Some investors prefer surfing on prediction of economic waves and change their portfolio allocations according to predictions.

In this respect, increasing portfolio allocation in cyclical stocks when the manufacturing PMI figures are strong and moving toward defensive stocks when PMI figures hint at slower activity could be a way to take the market by the horns for actively managed portfolios.

Cyclical stocks include energy and mining stocks, industrials, technology stocks, carmakers, pleasure and travel stocks, and retailers. While defensive stocks include utilities, consumer staples and healthcare stocks.

Some investors prefer buying options on their existing stocks, as an insurance for bad market conditions, to limit losses in case of a sudden market move. Of course, buying a put option, the right but not the obligation to sell a stock at a predetermined price at a predetermined date, allows investors to fix a minimum sell price if the market falls sharply, but it comes at a cost.

The higher the market volatility, the higher the cost of insurance.

This type of alternative investment products is often suitable for advanced and professional traders. Therefore, if you do not perfectly understand the product, it is better to avoid it.

Many readers are probably wondering is it a good idea to buy the dip? The answer is yes: buying the dip is great, if you are sure that there is no further dip.

We will discuss pros and cons of buying-the-dip approach in detail in our next article.

While a sizeable downside correction increases the temptation of buying the dip, some investors swear by ‘trend is your friend’ only, and chase temporary price advances to sell the tops until they consider that a bottom is hit.

It is however important to keep in mind that short-selling is a high-risk strategy and could lead to sizeable losses in the long-run. Hence, selling the top should be considered as a short-term, tactical move with a clearly defined take-profit target, rather than a long-term invest-and-hold approach.

The content in this article is provided for educational purposes only. It does not constitute investment advice, financial recommendations, or promotional material.