As the British economy begins to slow as a result of racing inflation, geo-political threats at Europe’s borders and increasing finance costs, a recession is potentially only a quarter away.
UK investors are eyeing up their investment portfolio and rightly wondering how to prepare for a recession.
Tweaking your portfolio to make it recession-proof is the goal, but is this objective actually achievable, and could it bring adverse consequences? Here’s a summary of our view.
How can you recession-proof your portfolio?
- Defensive sectors
- Low-beta stocks
- Negative correlation stocks
Defensive sectors are segments of the economy that are either insulated from the effects of a downturn or even step up a gear thanks to a counter-cyclical factor inherent in what they do.
Sectors connected to government, science, utilities, and energy tend to exhibit these qualities.
Low beta stocks
Beta is the degree of movement a stock moves by in relation to the overall market movement over the same period. On a day in which the entire market fell by 1%, a stock with a beta of 2.0 will have fallen by an average by 2%. The beta value is a multiplier of the overall market value.
A stock with a beta of 0.5 would have only fallen by 0.5% on average. Naturally, when volatility is high, investors will favour low-beta stocks as these will provide a smoother ride and cushion the effects of a slide in market index values.
Negative correlation stocks
Negative correlation stocks have a negative beta. This means that when the stock market falls, the stock in question tends to rise, and vice versa.
Only a small group of stocks exhibit this unusual price behaviour. Consider the types of businesses which might flourish during financial chaos:
- Listed private equity firms that specialise in distressed debt
- Bailiffs and debt recovery companies
- Insolvency accountancy practices
The downside of recession-proofing a portfolio
Recession-proof stocks are not tightly-held secrets, which means that active managers begin to favour these companies as soon as a recession appears on the horizon.
Therefore, their prices begin appreciating in anticipation of a recession rather than just before or during a period with negative GDP growth.
This places intense market timing risk on investors looking to enter and eventually exit such positions.
The exit is equally important as the entry, as the market view will cool on low-beta stocks during good times, as they typically fail to grow their earnings like high beta companies that true ride the wave of economic growth with a phase of aggressive expansion.
Therefore merely switching into recession-proof stocks during a recession may not be beneficial, thanks to market efficiency. One must actively win the race into these defensive sectors and then correctly time the appropriate time to cycle back into riskier assets to truly build an investment portfolio that would perform well during a recession.