Strategies To Hedge Against The Impact Of A Recession

In a report published in October this year by an institution called The Conference Board, it was estimated that the probability that the United States may enter a recessionary cycle within the next 12 months rose to 96%.

These estimates have been pretty accurate on previous occasions as they predicted both of the recessions that came after the 2007-2008 financial crisis and the 2022 COVID-19 pandemic.

For investors, the prospect of an upcoming recession can sound quite scary as it may hurt the performance of the stocks and could potentially lead to some bankruptcies. 

In this article, we share 4 strategies to protect an investment portfolio from the negative impact that a recession could have on the performance of stocks and other financial assets.

Strategy #1 – Using Derivatives For Hedging

Derivatives are financial instruments whose value is determined by the price of another asset – also known as the underlying asset.

Options are some of the most popular derivatives in the market and they can be used to protect a portfolio against a sharp downturn.

Now, you may be unfamiliar with how do call options work. An option gives the holder the right, not the obligation to buy (call) or sell (put) a financial asset on a future date at a pre-determined price.

By buying up some put options on broad-market indexes such as the S&P 500 or the Nasdaq, investors can gain if the market starts to go south as the value of these instruments will rise.

These gains can offset the losses produced by the investment portfolio during that same period.

In some cases, investors may opt to buy long-dated options, also known as long-term equity anticipation securities (LEAPS), which expire 12 months or more from the date they were purchased.

Strategy #2 – Buying Hard Assets

Hard assets are physical items that are typically considered valuable regardless of how the economy is doing. Some examples of this are gold, real estate properties, inventories, and vehicles.

Hard assets tend to be decent stores of value during recessionary cycles as their price fluctuates alongside the inflation rate. This preserves the purchasing power of the money invested in them.

If you are not fond of buying up these assets outright due to their high maintenance and storing costs, there are certain ways to get exposure to them via the financial market. 

For example, real estate investment trusts (REITs) can be used to allocate some money into this market. Moreover, some exchange-traded funds (ETFs) offer exposure to gold and other precious metal and free investors from the burden and risk of buying up gold bars.

Strategy #3 – Incorporating Recession-Proof Stocks

Recession-proof stocks are those issued by companies whose business is not too sensitive to a negative macroeconomic backdrop.

These corporations typically produce goods or render services that are considered essential to a certain group of consumers. That reduces the volatility of their top-line performance regardless of how the economy is doing.

Companies that sell staple food, cheap clothing, and tobacco are among these so-call defensive stocks. In addition, retailers and pharmaceutical companies may also fall into this category as people won’t stop buying groceries or medicine despite how their finances are.

Investors could incorporate some of these stocks into their portfolio to cushion the drawdown that equities in other more volatile sectors of the economy like technology, finance, and construction could experience.

They could either transition their portfolio allocation to assign more weight to these sectors or they could incorporate them progressively with the new money that they deposit to the investment account as part of a dollar-cost average (DCA) strategy or other similar methodology.

Strategy #4 – Investing In Inflation-Protected Securities

The United States has created a type of bond whose value fluctuates in line with the country’s inflation rate. These instruments are known as Treasury Inflation-Protected Securities or TIPS. 

The principal value of a TIPS is modified based on how the country’s consumer price index (CPI) fluctuates. Once the TIPS reaches its maturity date, if the value of the principal has gone up, the investor is entitled to receive the full value of the bond.

Meanwhile, if the value has gone down, the investor will still receive the nominal value of the bond. TIPS also pay interest periodically, every six months or so. The interest rate of these instruments varies depending on how the value of the principal fluctuates alongside inflation.

Bottom Line

Even though no tactic can fully protect a portfolio from the impact that a recessionary cycle could have on either the value of its assets or the purchasing power of the currency in which it is denominated, there are ways to cushion the blow.

Investors could either opt to use one of these strategies or all of them as they are not dependent on each other. For example, they can buy put options at the same time they are shifting their portfolio allocation to equities that are less exposed to the whims of the domestic or global economy.