If you owned a car, and you knew for certain that it would crash and burn in August 2020, what would you do?
Well for one, you would quickly buy insurance, to make sure you could buy another car. What else? You might consider selling the car to ensure that it’s not even an asset you own when it crashes. What else? Buy another car, so even when insurance is getting your claim prepared, you have a backup.
Great answers and they are all correct.
In effect, you will take appropriate risk management measures to protect yourself from loss. By buying insurance, you are retaining the risk of the car crashing, but you are limiting the downside exposure to you. By selling the car, you are avoiding the risk altogether. In buying another car, you are not just hedging but diversifying your carpool to ensure that the fall in one car does not affect your ability to move around
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If you owned assets (Shares, Cash, Bonds) and you knew for certain that there would be a recession in August 2020, what will you do?
The answer is you will do the same thing. You will:
- Hedge that event
- Avoid that event
- Diversify away the event
So, what is a recession? A recession is two quarters of negative growth, i.e. 6 months of the economy failing to grow. What this means is less demand caused by reduced purchasing by consumers caused by layoff of workers. The thing about recessions is that they are a part of the normal business cycle.
The business cycle is a constant cycle of peaks and troughs. What differentiates each economy is how long the expansions will be and how long the recession will be. The US for instance since the June of 2009, has recorded annual growth (a record).
A recession will happen, that’s a fact. The only question is when? That, we cannot say or predict. Yes, we can model out unemployment and spending scenarios, but an actual date is near impossible to determine in complex economies like the US. However, for an economy like Nigeria which relies up to 75% on a single commodity to fund imports, every economist will agree that if oil prices fall to $40 a barrel, Nigeria will drift into a recession.
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What Happens During A Recession?
A recession means that output produced in any economy declines. The real damage in a recession is a fall in consumer spending and capital investment caused by a fall in income earned by employees and business owners and general declining asset values.
As outputs fall, businesses are forced to lay off workers to cut costs; those workers laid off will cut back on spending, and thus a vicious cycle develops. One of the methods used to break out of a recession is government spending to jump-start the economy to revive consumer spending.
To build a recession-proof portfolio is to build a portfolio that:
- Is hedged against a general fall in asset values
- Allows risk avoidance
- Diversifies risky assets
Building the Portfolio
Two key objectives are thus very important: safety and liquidity. Any investment we select into our portfolio must meet these criteria.
So, consider a triangle, we start building with holding cash at the base.
Cash: Our portfolio must hold cash or near cash. Every investor must have an Emergency Fund where minimum of 3 to 6 months Non Discretionary expenses are held. Non-Discretionary Expenses are expenses outside the discretion of the consumer e.g., rent and medical bills. Your recession-proof portfolio must have this cash buffer. Cash as a percentage should not make up 15% of our recession-proof portfolio.
Short Term Money Market funds: Sovereign Issued Short Term Instruments like Treasury Bills make up the next stage of our portfolio. These instruments are near cash, as the Central Bank always offers a discount window where the holder of T-bills can convert these certificates to cash. The advantage of holding T-Bills is that your “idle” cash sits in a haven, earning a return but is immediately available to be converted to cash to take advantage of opportunities that arise like shares that are priced way below their market value. Some sovereigns offer Inflation Indexed Treasury Bills which pay an inflation plus return. T-bills hedging the portfolio Short Term Interest Rates should make up 30% of the portfolio.
Long Term Sovereign Bonds: Holding sovereign bonds in the portfolio acts as a buffer to falling asset values, as bonds prices are fixed (yields will fluctuate and are inverse with interest rates). In a recessionary environment, interest rates fall as the Central Bank attempts to boost spending. Owning long term bonds allow the investor to earn a fixed higher rate of return. Long term investment can make up 30% of a portfolio.
Real Estate: in a recession, buying real estate is a gamble because the property may pass a high value, but recessions produce illiquid markets, making it difficult to realize that real estate for profit. Thus, the way to buy quality real estate in a recession is via investment in REITs (Real Estate Investment Trusts). Buying allows the investor to exit his position, should he desire, by selling units of the REITs but it also offers a way to buy quality assets in the REITs at a reduced price. The investor should seek REITs that hold more of residential than commercial assets as even in a recession, rents will be paid. REITs also pay off a large percentage of their earning as dividend; thus this also serves as a good earning investment during a recession. REITS as an asset class can make up 10% of a portfolio.
Equities. Yes, equities fall in prices during recessions as companies post weaker results and have reduced sales, but even in a recession there are winners e.g., companies that sell necessities like baby food and utility companies that earn a boring but steady return.
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Equities that have a high dividend yield are also right for this portfolio.
Another way to invest in the stock market is through owning Preference Shares which are a hybrid because they are equity but pay a fixed dividend. A great investment to buy will be a convertible Preferred Stock. I would put 10% in high dividend yield stocks and preferred stock.
A recession produces falling prices, but some commodities like gold are negatively correlated to market uncertainty, thus their value rises as economic conditions falls. Also commodities that are staples like rice will do well.
Gold for instance can be bought by investing in gold ETFs like GLD
Our final recession protection asset allocation will look like this:
Short Term Sovereign 30%
Long Term Sovereign 30%
Real Estate 10%
This is a specific portfolio that is set up to protect assets from dissipation while generating cash to invest in opportunities. It’s is not recommended as a capital appreciation strategy.
Remember, a recession is simply a phase in a continuous economic cycle, keep this handy
This is not a recommendation to buy or sell any assets. Speak with your financial advise before making any investment.