Let’s discuss how to prepare or deal with an upcoming recession or a market crash.
Say you’re watching BNN or CNBC and they’re talking about an upcoming recession or stock market crash. You panic, you’re worried about it, and you don’t know what to do.
First thing’s first, let’s remember that the market prices accurately reflect the emotion of every single human being that’s investing, every single institutional investor, and every single pension plan that exists out there.
The buying and selling reflects the current feelings and emotions of the market.
There’s a lot of people that will tell you they knew the crash was coming. Make sure to be careful out there, as there can be a report one day that the market will crash for the next six months, then minutes later someone will say the exact opposite.
In reality, most of them do not know, and they’re just doing the best they can to be a talking head on TV. The key for dealing with a potential recession is to make sure that you have a portfolio built to absorb it should something happen
How can you take some risk off the table if you feel a crash is coming? Hopefully your advisor (likely a discretionary portfolio manager) has a plan in place for you.
If they feel a crash is coming, they should take the necessary steps to reduce the risk or capital that is exposed, or maybe even add some downside protection to your portfolio.
You will never want to be completely out of the market, because in reality, most people get these things wrong. If you would have sold all the times someone claimed a crash was coming and been out of the market for all of your portfolio, history will tell you that that would’ve been a colossal mistake.
Markets historically make new highs and will continue to make new highs for the next 100 years. The key is to reduce the downside exposure. If you believe a market crash is coming, what you should do is take a look at your actual Beta or your exposure to the markets.
How much is your portfolio moving every time the market moves 1%? Ideally, you’d like to target a high upside capture and a really low downside capture. When assets are correcting, how much of that downside do you capture and when markets are rallying, how much of that upside do you capture?
How do we do that?
One, you take a look at asset classes that perform regardless what happens in the market. That specifically can be something like a private equity deal, a limited partnership, or a real estate transaction that is uncorrelated to the market.
We take a look at maybe adding some private debt or something that generates a little bit more return but is not correlated to the markets as well.
You will also want to have some lower Beta stocks. This could be a utility stock, potentially an infrastructure play, anything that is less correlated with the actual stock market. You could switch from a growth to a value play.
You want less companies that are super volatile and more companies that are going to pay their dividends. Strong balance sheets, maybe more large cap companies. These are all strategies you could use if you think a stock market crash is coming.
You could also use a variation of either principal protected notes or equity income notes. These are structured notes that exist so that you can control your downside. You can say, I want this much exposure to the stock market, but I only want X% of the downside. You can be really, really flexible.
If you’re doing this on your own at home, you can’t be flexible. But if you’re working with a portfolio manager who’s able to custom notes for you, then you could actually protect the downside quite a bit by building some principal protected notes or some equity income notes that would generate income.
Therefore, if the market crashes, that principal is protected. These are some of the ideas in addition to the alternatives, private debt, and the lower Beta equities.
I will say this; going completely to cash is likely not a good idea. You’re probably going to be wrong. When you think the crash is happening, that’s when the market will rally.
You’re going to be so timid, and worried about when to get back in that you’re never going to get back in. You’ll end up missing a year of gains, which is too expensive to miss.
Even if there is a crash, just remember this; 100% of the time in the history of the stock markets in Canada and the US, when there’s a correction the market has made a new high.
It’s something to factor in, and it’s something to consider. You want to protect that downside, but you don’t want to underexpose yourself and get out of the market completely.
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