Plan now to turn an inevitability into better returns later.
A few months ago, it seemed that a recession was on the horizon. Now, it seems as though investors expect the market rally to continue. All this really tells us is that nobody can know exactly when a recession happens, only that they’re an inevitability.
While the last recession was brutal, most recessions are short, lasting less than a year. In that time, investors can make or break a decade’s worth of investment returns, depending on how they react.
There are two key things investors can do starting today to prepare for the next recession—or even the next bear market, which can occur even if economic growth continues to hum along. By following these tools, investors increase their chances of long-term investment success.
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Tool #1: Review What You Own and Weed Out Poor Performers
Most investors get into trouble during a recession because they decide they want to liquidate their investment portfolio all at once and get into cash. This rush to liquidity, which typically arises as others do the same, create a huge selling pressure on the market that ensure investors book a loss now, and have less capital to put to work in the future.
In order to mitigate this problem, today’s investors should look at their holdings, with an eye towards weeding out some of the poor performers now. A company struggling during a period of economic strength will likely be in even worse shape when its existing customers are looking to cut back. That may be the case right now with natural gas, which should be starting a seasonal rally, but whose long-term price keeps getting pushed lower and lower from improved drilling technology.
Besides getting the poor performers out now, a recession tends to hurt companies in proportion to how leveraged their balance sheet is—a big reason why bank stocks cratered 80-90 percent during the last recession.
Investors should look to only own stocks with lower amounts of leverage relative to their industry. These companies will also likewise sell off in a recession, but they’ll have the financial strength to survive—and, more importantly, buy the assets of competitors up at fire-sale prices, ensuring their over-performance going forward. These companies can be bought before, or even during, a recession to get this built-in advantage.
A poor performer—or likely future poor performer during a recession—should be sold to free up cash, pay down any high-interest debt, or otherwise improve your personal balance sheet during a recession.
Tool #2: Increase Your Focus on Cash Generation, Not Total Returns
There are many ways to make a profit in the stock market. But many short-term gains will be wiped out by short-term losses from trading. Astute investors who focus on investments capable of generating high returns of cash year-in and year-out do a great job of protecting themselves during a recession.
There are many ways to improve cash flow, from investing in real estate investment trusts, high yielding dividend payers, or adding a covered-call writing strategy on existing positions. All these high-cash generators also help investors to stay invested during a recession instead of going to cash where they miss out on the best returns from the subsequent rebound.
This is also a tool that’s handy to have during a recession itself. Many companies maintain their dividend payments and even increase them during a recession—and investing in some of those recession-proof names, like McDonald’s (MCD) and Wal-Mart (WMT) may sound boring, but during a recession, their shares will drop into a better buying range where investors can get an historically high average cash return via dividends.
If you think of your personal assets as a business, you can improve your likelihood of coming out ahead in a recession by simply doing two things. First, weed out your poor performers so that you lower your leverage and increase your holdings in what does work. Second, focus on your cash flow. Even as stocks fluctuate, cash flow can offset a lot of the uncertainty there and put you on the path forward to success.
These two tools will ensure that investors looking to survive the next recession have the financial strength to do so—and come out ahead over time as a result.