The current market situation has left many investors wondering if it is possible to structure an investment portfolio so it will not feel the pain of a recession and the lower stock prices that generally accompany it. The sting can be avoided if someone avoids owning stocks altogether, but this is often not an acceptable answer—even for the average investor. In the long run, the damage of a recession can be avoided if the investor avoids selling stocks during a downturn. However, this can be difficult during times of bad news.
At Henssler Financial, we believe the most effective way to make your portfolio “recession-proof” is to follow a few simple rules. These rules should be followed in both good and bad markets.
The first rule is to make funds available from liquid investments for an emergency so that other investments do not need to be liquidated.
A recession can bring concerns other than the value of your stock portfolio. You may be concerned about your job. When the economy slows down, unemployment rises. The lack of a paycheck is generally of greater concern than a bad day at the stock exchanges.
The first rule to follow is to establish a plan to cover emergency reserves. In general, we suggest you have between three and six months of spending needs available in a safe, liquid investment, such as, a money market fund. If all your family’s income is derived from one source, six months of spending needs is a good target for your emergency reserve fund. Saving the equivalent of three months for emergency needs is usually sufficient, if your family has numerous sources of income (i.e., both spouses work, rental income, investment portfolio income, etc.).
Your emergency reserves should be held in an investment in which the principal is safe and readily available. Money market funds, savings accounts or other liquid cash equivalents are preferred. Some feel comfortable using credit lines as emergency reserves. This is acceptable, as long as the additional risk is understood—debt might increase at a time when funds are tight if the credit line needs to be tapped.
When your short-term emergency cash needs are covered, the next rule focuses on the asset allocation for your remaining investments. Our firm follows an asset allocation strategy we call our Ten Year Rule. This rule states that funds you expect to need within 10 years should be invested in fixed-income investments, while remaining funds should be invested in high-quality, individual common stocks or mutual funds that invest in common stocks.
By following our Ten Year Rule, you should be able to avoid one of the mistakes we mentioned earlier—selling stocks in a down market. If the funds you need are not invested in the stock market, stock sales are likely not needed for you to cover your spending needs. This, in turn, should allow you to get through a tough market, like a recession, without unnecessary stock sales.
Stocks have outperformed other asset classes over long periods of time. Over any one, two or five-year period, stocks can perform extremely well, as in the late 1990s, or poorly as in the early 1970s. No one can “gaze into the crystal ball” and tell what tomorrow, next month or next year holds for the stock market. However, when you have a general plan regarding your retirement date and your spending needs, you should gain more control over your personal financial picture.
When the portion of your portfolio that should be invested in stocks has been determined, we suggest only owning shares in companies that are financially strong. A strong company should not only play a leading role within its sector, but it should do so with efficiency, which is reflected in sound financials. A strong company receives scores from rating agencies, as well as the capital markets, through high debt ratings and low cost of capital. To gain the best debt ratings and lowest cost of capital, companies must show superb liquidity ratios, strong cash flow and sustainability of earnings. A good indicator of the survivorship of a corporation is how the capital markets perceive the company.
At Henssler Financial, we recommend purchasing stock in companies that are at least rated “A” by Value Line for financial strength, at least “2” by Value Line for safety, or at least “A-” by Standard & Poor’s for quality. If you are a longtime client of Henssler Financial, you have heard the above mantra repeated since the day you became a client. We believe a consistent, steady approach to investing makes the most sense for any investor. This applies to recessions as well. Stay with your program. Continue to make the same smart choices. Give the economy and the equity markets time to recover and return to better days. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].