Tips on investing during a recession

INVESTING during a recession/stagflation is more challenging than during healthy, economic conditions. However, since a recession is a normal part of a business cycle, investors, should always be prepared to deal with their investments in such times.

Definition of recession/stagflation

In economic terms, a recession is a business cycle of contracting economic activity. In other words, a general decline in the economy activity over a period of time, usually for two consecutive quarters. The most common definition of a recession is "two down quarters of gross domestic products (GDP)."

How does a recession occur?

Recessions usually occur when there is a widespread drop in spending, often after an adverse supply shock or the bursting of an asset bubble. For example, Malaysia suffered a recession during the 1997 Asian Currency Crisis as well as the recent 2008 global financial crisis. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing the money supply through reducing interest rates, raising government spending and cutting taxes.

During recessions, demand for most goods and services usually decline. This causes the demand of goods to decline faster than the supply. So, all things being equal, we should expect the level of prices to fall as well.

However, here is the tricky part. Sometimes, inflation (high prices) continues to persist during recessions. When this happens, stagflation occurs. A recessionary period with a high inflation rate is known as stagflation, a concept made famous by economist, Milton Friedman.

Economists offer two explanations for why stagflation occurs.

First, stagflation can result from an unfavourable supply shock, such as an increase in the price of oil. Such an unfavourable supply shock tends to raise prices and slows the economy by making production more costly and less profitable.

Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, in a recession, central banks can inadvertently cause inflation by cutting interest rates to historically low levels, which results in excessive credit growth.

As an individual investor, how do you protect your unit trust investments or invest during this difficult time? We highlight three important guidelines.

Guideline 1: Spread your risk, be diversified

The number one rule in investing is to diversify. Diversification is a standard investment strategy used for risk reduction. Try to keep a portfolio that covers equities, bonds, currencies and cash.

Most stock investments with the exception of some 'recession-proof' industries, usually do not perform well during recessions because of their low sales and earnings capacity.

On the other hand, hard currencies such as gold, precious metals and bond investments usually make them attractive investments during recessions. This is because the value of hard currencies such as gold and precious metals remain stable or even rise during periods of economy uncertainty. Bond investments also do well during recessions because falling interest rates lead to higher bond prices.

Therefore, look out for unit trusts that offer a diversified portfolio such as a balanced fund or diversify your portfolio by holding a mix of different unit trust funds consisting of equities, bonds and money market instruments.

Guideline 2: Practise "Ringgit Cost Averaging"

"Ringgit Cost Averaging" (RCA) is a disciplined investment technique to help investors weather through periods of market volatility. Under RCA, an investor will invest a fixed amount of money in an investment at regular intervals. For example, an investor might choose to put aside RM1,000 for unit trust investments every month. This technique ensures that the investor pays a mix of higher and lower prices for the investment, rather than taking the risk that a particular day's price might be high or low. During times of recession, this technique allows an investor to buy more units when the market is down. See Table 1 for a hypothetical example.

An investor who invests RM1,000 at regular intervals over 5 months, ended up purchasing more units and at a lower average cost per unit of RM0.4896 compared to a cost per unit of RM0.50 with a lump sum purchase at the start of the investment period. This is the result of the "ringgit cost averaging" effect.

Guideline 3: Remain calm, think long term

Many investors often panic when they see their portfolio values fall due to recessions. One should remain calm during these tough economic times and discuss with his or her unit trust consultant about their investment goals.

One can either stay put or to make some changes to their portfolio but should not react with panic and fear. Getting rid of all your investments or investing everything into one asset class in order to stay safe may not be good.

Remember that recessions are a normal part of a business cycle and do not usually last more than a year. In this regard, taking a long term perspective in investing is much wiser.

For long-term investors, the prudent course is to construct a portfolio that favours growth but offers protection in a recession.

Conclusion

Investors can always find safe investing opportunities in a recession by diversifying their portfolios, maintaining discipline by following their investment plans and staying calm by taking a long term investment approach. In doing so, they can weather recessions and maybe even benefit from it.

This article is contributed by Public Mutual Bhd. For more information, you can call Public Mutual Hotline at 03-6207 5000 or visit [You must be registered and logged in to see this link.]