Wednesday, December 05, 2007

Protecting Our Savings Against A Recession

Economists have correctly predicted nine of the last five recessions. -- Paul Samuelson, economist

Since we depend on investment income, the possibility of a recession has me a bit concerned. I've been seeing more articles on the chances of a recession and how to invest for an expected recession. Examples of articles include: Protecting Your Nest Egg in a Recession and Use ETFs to hedge your bets.

The problem is that no one really knows when a recession is coming and how long it will last. So recession proofing one's savings too early or for too long can be costly in terms of lost returns. My personal preference is to set aside part of my savings to protect against a recession, and still stay in the market.

Here are some of the approaches I like:

  1. Reallocate a higher percentage to investments that can do well in a recession. I will stay in equities but allocate a higher percentage in CDs, bonds and cash. For example, I may go from 35% cash, CDs and bonds to 45-50%. That way I will still participate in appreciation of the stock market, should a recession be delayed. I still remember the story of a colleague's friend who went 100% cash in 1985 and was still in cash in late 1999. He missed the crash of 1987 but also missed the significant gains of the stock market through 1999.

    For the equity portion, I will skew more towards the large cap growth stocks, which tend to do better in the later stages of a bull market. I have also slightly increased the proportion invested in foreign stocks.

  2. Keep funds that are needed for the next 3 years in cash or cash equivalents. I will keep near term needs such as our living expenses in cash, laddered CDs or laddered bonds. That way we can get the money we need without taking losses in the stock market, if there is a recession. If we had children in college, we would also use this strategy for college tuition.

  3. Set aside a small portion of funds to short individual stocks. When a recession does happen, I will use a small percentage (about 1-3%) of our savings to short individual stocks, using a system developed by a colleague. Also, I have invested in a bear fund, called the Prudent Bear (BEARX), which shorts individual stocks and goes long on gold stocks. This fund had done relatively well, even when the market is rising.

Here are some approaches I will probably not use:

  1. Insure my portfolio against losses with put options. Buying index puts or individual stock puts can be very expensive if done frequently. And since options are very time sensitive, it is critical to be good at timing the market, which I have not been very good at doing regularly.

  2. Hedging my portfolio with funds or ETFs that short indices. I think going against the market is a bad bet for the long term, and it can be a bad bet for the short term. In today's volatile market, a single piece of good news can cause an index to move up significantly in a day, making a short position a losing one. As I noted above, I prefer shorting individual stocks or a fund that shorts individual stocks.

The only good news about a recession is that the U.S. economy usually recovers and gets stronger. At this time, I still think it is a good bet that the U.S. stock market will be higher 10 years from now.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial or investment advice. Please consult a professional advisor.

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