How to Protect Investments During Economic Crises

Despite some signs of inflation moderating, such as gas prices coming down over the summer of 2022,ⁱ much uncertainty and uneasiness remain. The Federal Reserve continues to eye interest rate increases,ⁱⁱ and geopolitical tension remains high in multiple places around the world.

Amidst these conditions, markets have been volatile.ⁱⁱⁱ Investors are left wondering how to protect their investments in the event of a recession or similar economic crisis.

Even if the U.S. avoids a full-blown recession, investors still might need to brace for bumpy times ahead. Stock markets, bond markets, real estate, and other asset classes have a lot of question marks around them.

With the right preparation, however, you can potentially smooth out the ride and position your portfolio for long-term success.

Diversify your portfolio with a recession in mind

Experienced investors know to diversify portfolios so they can try to optimize investment risk/reward. But what does that actually look like, especially with a shaky economy hanging over your head?

While the specifics still depend on your circumstances (e.g., your cash flow needs and risk tolerance), consider how you might benefit from diversifying with the following assets:

• Commodities: Commodities ranging from oil to gold could potentially help you hedge against high inflation or other types of economic crises. If you’re feeling the effects of high gas prices at the pump or your home’s energy bills, for example, you might be able to offset that with gains from energy investments.
  
  “Commodities funds can capture spikes in commodities prices that precede inflation increases. Still, Morningstar’s director of manager research, Russ Kinnel, recommends keeping commodities fund positions small because commodities prices are volatile and hard to predict,” notes a Morningstar article.^iv


• Treasury and municipal bonds: Adding government bonds, including different types of Treasury bonds and municipal bonds, can potentially give you access to relatively low-risk assets that provide cash flow and/or the potential for long-term gains.
  
  “Although bonds have not performed well lately and lag stocks over the long term, high-quality bonds are generally safer than stocks. That’s why they are appropriate for ratcheting down risk,” notes a New York Times article.^v
  
  I bonds, for example, are Treasury bonds that pay a fixed rate plus an inflation rate. That combined rate adjusts every six months, and in periods of high inflation the bonds can provide relatively high returns. I bonds purchased from May-October 2022 paid 9.62% annual yield for the first six months.^vi You can only purchase up to $10,000 in electronic I bonds per calendar year, but that, along with other government bonds, could be a good way to diversify your portfolio.


• Derivatives: Another way to diversify your portfolio is to add derivatives. These investment products might help you balance different types of risks or gain exposure to underlying assets that you might not directly invest in.
  
  For example, options (as explored in more detail later in this article) can help you bet on the direction of the stock market without having to necessarily put as much capital at risk initially. And futures can give you exposure to some types of commodities, such as orange juice, coffee, or oil.

Create a long-term investment strategy—and stick to it!

When the market starts to decline, or when you hear headlines about difficult global conditions, it’s tempting to change your investment strategy. Generally, however, you want to create and stick to a long-term investment strategy, rather than getting caught up in short-term changes.

That’s not to say that your portfolio has to be of the set-it-and-forget-it variety. Sometimes you might change course a bit, like if you have another child and need to save more for their education. And maybe you’ll spot some opportunities to make small adjustments, like adding more I bonds during periods of high inflation.

But consider building that wiggle room into your long-term investment strategy, while most of your assets stay put.

As the saying goes, “time in the market beats timing the market.” In the long run, assets tend to recover and surpass pre-recession levels. Even after the dotcom bubble burst at the turn of the century, the NASDAQ eventually retook those previous highs.^vii Looking at the market over the long run, those crashes look more like temporary blips.

So, if your stock holdings start to drop, for example, that doesn’t mean you should automatically switch to bonds to avoid further losses. That type of move should generally only be made if you’ve experienced a long-term change, such as entering retirement and wanting to switch to a more stable cash flow source.

Continue to invest in quality companies

As part of your long-term investment strategy, you likely want to continue investing amidst difficult market conditions, rather than stay on the sidelines. It’s hard to predict when markets will recover, so persevering can provide you with dollar-cost averaging opportunities and enable you to keep growing your investment portfolio.

That said, you might want to give yourself the leeway to adjust course slightly. For instance, you could put extra cash into companies that you think are more likely to thrive during and after a recession. Doing so can help you scoop up assets at relatively discounted prices. If others are selling out of fear, the price may drop. But if you have confidence in the long-term outlook of these companies, you can get in at a lower price.

As Santander notes in the Q3 2022 Global Market Outlook, it makes sense to turn to high-quality companies in times like these.^viii Companies with good cash flow, minimal debt and liquidity needs, and healthy margins could be attractive.

These companies could be better placed than competitors to weather storms. If a company needs to keep issuing high levels of debt, for example, then that could get more expensive as interest rates rise. In contrast, a company with a healthy balance sheet might be able to make it through lean times and come out the other side ahead of the pack.

Think twice before investing in speculative companies

In contrast to turning to high-quality companies, consider avoiding overly speculative companies.

A startup that has little path to profitability anytime soon, for example, might not survive a period where borrowing gets more expensive. And if you’re following the hype train that drives asset prices up, then those assets could also come down quickly if other investors need to pull their money out due to cash flow needs during a recession.

“Recall that the dotcom bust was a reversal of the large-scale listing of companies, many of which had nothing more than a promising business idea, like Pets.com, eToys.com, and Webvan, all of which had little or no revenues. They were burning cash while experimenting with half-baked business ideas,” notes the Harvard Business Review.^ix

That’s not to say that you have to immediately pull your money from speculative companies, especially if you have a long-term plan.

Consider calculated investment risks

While you might not want to take a huge gamble on speculative companies, an economic crisis could present opportunities to take calculated investment risks. In other words, you might find chances to put money into assets that have high potential without necessarily betting the farm.

Some examples include the following:

• Put options: Put options essentially enable you to short sell without taking on quite as much risk. If you truly believe the market is heading downward, then a put option could be rewarding. This type of asset gives you the opportunity—but not an obligation—to sell a security at a given price.
  
  So if a stock falls below that price, you could exercise the option and make the difference between the current market price and what you have the option to sell it for. If the stock doesn’t fall, then you would just be out the money spent on the options, which is generally a small portion of the share price, as opposed to the unlimited losses you could face with traditional short selling.


• Call options: The opposite of put options, calls give you the right to buy securities later on at a given price. So, you might think that some types of stocks will lose value, and thus buy puts, whereas others might go up, and thus buy calls.
  
  For example, you might believe that among competing tech companies, one will survive a recession better than others. But if you don’t want to put too much cash into this company right away, you could buy a call option and see if that hunch turns out to be true. If not, you might only be out the money spent on the options, as opposed to exposing yourself to potential stock price declines.


• Actively managed exchange-traded funds (ETFs): Many investors turn to ETFs for liquidity and often low fees, but you don't always have to invest in passive ETFs. Some investors turn to actively managed ETFs, particularly during periods of market volatility, if they believe that fund managers can navigate these periods better than how the index will perform.
  
  For example, if a fund manager can find those high-quality companies that make it through a recession better than competitors, then they could potentially outpace the index.

Overall, investors can take many routes when it comes to protecting investments amidst challenging economic times. If you keep a long-term investment strategy in mind while exploring small adjustments with a level-headed mindset, you can potentially protect your investments and secure your future.

To learn more about handling economic uncertainty and tap into expert advice, please reach out to our team of financial advisors at Santander Investment Services.