How to Survive a Recession

LESSON 27: Diversify Intelligently

Holding a portfolio of different types of assets to reduce risk is a technique espoused by nearly all investment professionals. The reasons for diversifying are particularly evident during recessions as unexpected bad news occurs on all fronts.

The key to successful diversification is to focus your assets on a range of investments that have a higher chance of growth or stability in a recession.

You should diversify into defensive sectors such as consumer staples, bonds, defense or precious metals.

While diversification is a sound strategy to spread risk and increase risk-adjusted returns, over-diversification actually decreases returns. “Buy and forget” investing with equal diversification across all sectors at all times is not a sound strategy, because the under-performing investments put a drag on the returns of those that are outperforming. A long line of investment geniuses including Warren Buffett advise focusing on only a limited number of sectors wherever they occur in any given economic cycle. The key market sectors to diversify into during a recession include bonds, defense, consumer finance, real estate, precious metals, biotechnology, healthcare, and entertainment. You should also consider your home and any other marketable assets such as collectibles in the mix. By focusing your assets on these sectors and pulling assets out of falling sectors, you significantly improve your chances of capital gains while still achieving the benefits of diversifying your portfolio.

It is important to diversify early. The best time to begin diversifying into other sectors is at or near the prior market top before the recession becomes evident. If you shift capital out of growth sectors such as technology early, you sell high and shift into defensive sectors before the market does. Since picking market tops is exceedingly difficult, it is best to follow the large institutional investors. A good indicator is the percentage of investment capital held in cash by mutual funds. Most mutual funds invest only on the long side, which means they often go to cash when the market is turning down. Trillions of dollars in market capital shifts out of growth stocks, into cash, and eventually into defensive investments as a recession forms and accelerates. Getting in early with the big guys in the key sectors allows you to ride the wave as smaller investors pile in.