Gold as an investment

How To Recession-Proof Your Investment Portfolio

Sep 23, 2022

Amir Baluch is the founder of FinancialWellnessMD , which offers a range of financial educational materials for medical professionals.

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The vast majority of individuals’ financial and retirement plans are not prepared to weather a recession or similar economic downturn. How can you, as an investor, minimize or stop the damage, avoid being wiped out and perhaps even come out on top?

I’ve now lived through several major economic turns. Very early on in life, I saw how it can devastate finances. The next time I fared better. I’ve since kept a keen eye on what’s next and have developed my finances and investment portfolio to not only survive another downturn but also thrive through it.

First, we must identify the risks, then what money moves can strengthen your position, followed by swiftly making the right adjustments.

The Likelihood Of A New Recession

Another recession is almost inevitable. It is just the way that the world, economy and finances work. It’s not a matter of if, but when.

Looking at historical cycles and patterns, the market normally predictably turns every seven to 14 years or so. Of course, this can vary and be influenced by various other crises, monetary policy, stimulus and artificial market manipulation. Sadly, many investors have no plan, even though a shift in the economy can be a great thing if you are positioned to benefit from it.

Recession Vs. Stagflation

When there is rampant inflation, the Fed’s answer is to begin raising interest rates. Expectations are that several substantial hikes should cool the economy, though, in order to stomp out inflation, they would typically need to raise rates to match inflation. Historically, rates have topped 14% to 20% in times like these.

When the economy flatlines but inflation doesn’t stop, we can fall into a period of much-feared stagflation, which means even without capital losses in the stock market, you are losing without the right investments. The buying power of your savings, investments and retirement accounts is simply going down every day.

If your money is devaluing by 30% per year due to inflation, your $1 million nest egg has dropped to being worth just $700,000 this year. Next year it will just be $490,000.

The Bottom Line

We all need to be prepared for times like these. We all need downside protection and investments that can benefit from inflation. By all means, when it is raining gold out there, put out a really big bucket. Sadly, most aren’t watching for the holes appearing in that bucket and how fast it can all flow away when the market turns on them.

Diversification In The Stock Market

The real danger out there is that most investors are not diversified well at all. Many believe that they are because they have invested in many different stocks or funds at the advice of their broker or 401(k) plan administrator. Sadly, this isn’t real diversification.

It is vital to watch the correlation between the performance of your different investments. While there might be a handful of exceptions, when the stock market melts down, it pretty much all goes down. Not only to a point of correction but also thanks to panic buying, it notoriously overcorrects. That’s why many woke up in 2008 to see they lost $70,000 or more overnight.

Public stocks are tightly correlated. Some will always believe in investing in them. The point is that you need a greater variety of investments in your portfolio. It simply doesn’t matter if you have 10 publicly traded stocks or 110, you are not safe.

Understand Correlation Ratios

The problem with publicly traded stocks is that their performance is tightly correlated, meaning that they move together. When they are going up, they are mostly all moving positively in the same direction. When they are going down, they all go down together. That’s a huge financial problem and one that always seems to rear its head just when you need the money the most.

The key to building a recession-proof portfolio is to have a mix of investments and assets that will not all suffer during these times. In the investment space, we refer to this in terms of correlation ratios.

These ratios are measured on a scale of +1 to -1. A correlation ratio of +1 means that two assets move in perfect positive correlation to each other, like public stocks. A correlation ratio of -1 means that they are synced and correlated in a negative way. They are opposites. Like a pair of scales, when one goes up, the other goes down. So when your stocks go down, this type of asset will go up in value.

A correlation of 0 means that there is zero correlation between two assets. Just because one goes down does not mean the other will predictably go up or down at the same time.

True Diversification

In my opinion, building up to at least seven to 10 types of investments and assets is ideal, each with varied correlation ratios. However, if you are only in the stock market, then getting to five to seven types of diversified investments as quickly as possible could make all the difference in your financial future. This means at least six separate types of investments and assets classes aside from anything you have in the public stock market. Look for investments with a low correlation to the changes in the performance of your stocks or investments that move in direct opposition to them.

How To Diversify Your Portfolio

Experienced investors who have been through these cycles before shield their wealth from these economic changes (and benefit from them) by investing much more in alternative assets than the public stock market, bonds and cash. They choose investments with much less correlation, such as: private equity investments, real estate, promissory notes and debt investments, cryptocurrencies and precious metals.

Summary

Sooner or later another recession is inevitable. One of the best solutions to prepare is to better diversify your portfolio, so consider adding some types of alternative investments to your own holdings.

The information provided here is not investment or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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