Seven dos and don’ts before the next recession hits

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It’s been more than a decade since Canadian investors have experienced a recession – and many have forgotten what an accompanying stock-market plunge feels like. Most of us don’t react well to stressful situations, particularly when it comes to money-related matters. So, preparing ourselves mentally now is a good idea.

Here are seven dos and don’ts for investors before the next recession hits:

DO look back at previous recessions

The next time we receive confirmation from the Bank of Canada that the economy is in recession, many investors will have an overwhelming urge to react. They need to take a step back and ask themselves what they did with their portfolios during previous recessions.

There are two possible answers: They got too nervous and liquidated their portfolios, in which case they now, hopefully, have enough self-awareness to know they missed out on some spectacular returns the following years. Or they invested when the value of assets fell below their true worth – and are now very happy about that decision.

The best returns tend to happen after a recession, but investors need to have some faith and liquidity left to be able to invest at that time.

DON’T try to time the next recession

Even if many experts will continue to point out that the next recession is just around the corner, the reality is that recessions don’t work on a set calendar. We will likely learn that a recession is taking place once we are actually in one.

A natural reflex for many investors will be to get out of the markets just before the recession happens, then get back in when it’s over. Although this approach may sound logical, it’s extremely difficult to pull off. When trying to time a recession, you need to be right twice: when you get out and when you get back in.

Even if investors manage to find the right time to get out of the markets, they may miss the right time to get back in – and that could hurt a lot in the long term. Think about people who have been holding on to cash since 2008, for example.

Finally, the average return of the S&P/TSX Total Return Index 12 months after the previous eight recessions in the United States was 14 per cent, so you really don’t want to miss the recoveries. (See table below.)

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DO take a proactive approach to asset allocation

The idea of a pending recession alone makes some investors so nervous they can’t even sleep. So, they need to do something before the recession actually takes place. Great investment returns aren’t just about maximizing risk; they’re mostly about maximizing the risk investors could expect to stomach.

That’s why some individuals should lower their exposure to equities ahead of time to help them stay invested when the markets tumble. This approach will help those investors avoid liquidating their investments when the recession takes its toll.

For most investors, growing their wealth is linked directly to their ability to harvest the power of compounding returns – and the first rule of compounding is to never interrupt it.

DON’T assume it will be as bad as 2008

When we think back to previous recessions, the worst ones are usually top of mind. That’s just human nature. The funny thing is that even though we may be in a recession, the stock market is not automatically going to go down the drain. Since 1960, the S&P/TSX Total Return Index produced an average loss of 6 per cent during U.S. recessions. Investors must be willing to accept that some recessions will produce big down markets while others can be accompanied by positive returns – and they won’t know this information beforehand.

DO diversify your portfolio

During the past 20 years, various new asset classes have been made available to investors to help them diversify their portfolios. Many people don’t see the benefit of diversification when the markets are going up, but the usage of alternative asset classes such as real assets and liquid alternatives can help a lot during volatile markets.

The biggest benefit investors receive from diversification is not a more optimized portfolio – even if that’s a real positive. Rather, it’s the reduced risk of liquidating their investments at the worst possible time.

DON’T wait for a recession to deal with its impact

For investors, having a good grip on their ability to accept a big downswing in the markets is an important consideration before the next big one hits. They don’t call it a market crash for nothing. It’s normally because it happens quickly and without warning. During these times, investors don’t want to be rethinking their risk tolerance and changing their portfolios as their emotions will likely be running the show.

DO have a financial plan in place

A financial plan is a process, not a one-time thing. This process proves its worth during stressful times such as a recession.

That’s because investors will realize that a drop in the markets has already been baked into their financial plans and will not put their long-term life goals at risk.

Jonathan Durocher is president of National Bank Investments Inc. in Montreal.