In Morningstar's Investment Outlook 2023, Mike Coop, chief investment officer EMEA, outlined the most common mistakes investors make during times of recession. As the world's economies are now starting to slow, we took the chance to delve a little deeper into the subject. How should one actually deal with an upcoming recession and is there any way of emerging relatively unscathed?
Johanna Englundh: Morningstar has released an investment outlook for 2023, and we can't really talk about 2023 without mentioning the possibility of a recession. But how should we deal with one, and what are the biggest mistakes investors can make? I have one of the authors of the report with me, Mike Coop, and he is going to give us all the tools that we might need if entering a recession.
Mike, first of all, how have recessions affected the stock market historically?
Mike Coop: Hi, Johanna. It's great to be here. And that is a fantastic question to ask as right now all you read about is recession. So, before we dig into that, I think it's quite good just to remind ourselves of what the whole point of investing is, as we think about how to deal with recessions.
Usually, for most people, it's one of two goals we're trying to achieve. The first is either to build wealth to meet a specific lifestyle goal, like retirement, saving for a home, education and so on. Or it can be to fund our lifestyles in retirement as we sell down our assets or generate an income and try and preserve capital. So, that's really the yardstick we should be using as we measure our success in dealing with any scenario.
With that in mind, let's look now then at recessions and what that really means. In its simplest form, recession is really an economic scenario where companies and people are spending less money than usual. That means as one person's spending is another person's income, that drop in spending means that company revenues go down. It also tends to mean that household incomes come down as companies respond by cutting their costs, and that means unemployment goes up. So, that's the background to it.
When you get these recessions – and we've got over 150 years of data to look at to see how long they last – they tend to go anywhere from six months to three years with at the extremes it being longer than that. The important thing is, they do eventually end. So, whilst we can be focused on them, most of the time the economy does grow. And so, these are somewhat unusual events.
For investors, what that means in practice is that share prices do sometimes fall in recessions for companies, and in particular, industries where they're seeing the biggest hit to their revenues and their profits. So, typically, what happens is, behaviorally as investors, we are hardwired to expect that whatever has just happened to us will carry on, particularly if it's extreme. So, when conditions get bad, when we see the profits falling, we think, oh no, what could go wrong? And we don't tend to think about what could go right. So, investors get too gloomy, share prices fall way more than they should. And so, for a brief period of time, you get those markets selling off. And so, that's typically what happens to share markets, and that's typically how you should think about recessions in terms of the fact that they don't last forever, and they have this somewhat temporary effect.
JE: Okay. So, it can be a bit of turbulence then on the stock markets. But you have, however, listed three requirements on how to successfully manage a recession. Can you tell me a little bit more about these?
MC: Yeah. And I think this is helpful in terms of luring ourselves off the habit of looking at a stock market moving down and asking the question, did we do better or worse and just focusing back on those goals. So, the first thing is, be goal-oriented. If you've set a goal, you wanted to save a certain amount of money in a certain time period, and you're on a path to doing that, and if you find that you're below where you want to be, you're not quite tracking, if possible, try and save a bit more money in those situations. Because if you can save more and invest more when you're falling behind, that's often the best way in the long run to catch up. And that's because, usually, – we'll come on to that in a minute – it's a good time to buy assets that are often cheaper than usual. So, focusing on your goals and measuring your progress on those, and if necessary, trying to save a bit more and invest a bit more.
Secondly, stay the course. And to do that you've got to start off having a well-diversified portfolio. What does that mean in practice? It doesn't mean a Noah's Ark approach to having everything under the sun. It means that you need a range of asset classes and markets which are specifically designed so that they will be behaving differently in different scenarios, not just the one that you're in. So, we want to also make sure that as well as having a diverse range of assets, we avoid the highly speculative investments. We've seen crypto come off spectacularly. That's not an asset that has a cash flow and doesn't have any regulatory protections for investors.
So, make sure you're not holding lots of highly speculative investments. And when you've got this diversified portfolio, that is what you need to meet your goals and generate the right amount of return you need to stick with it and not be blown off course buy markets moving up and down. That's the second thing.
The third thing is to use valuation to tilt the odds in your favor. What do I mean by that? What I mean is, within share markets and within fixed income markets, at any point in time, investors can get carried away. They can become overly pessimistic about the future or indeed, overly optimistic about the future. And in recessions, typically, what happens is they tend to get overly pessimistic about most things. And so, buying a market or having more invested in a market, which is cheaper than usual, and which already reflects a very pessimistic view tends to lead to better outcomes, because the worst is already priced in.
So, in our portfolios, we try and tilt the portfolios to the assets that offer better value, that are more pessimistic and where we can be confident the asset is going to survive and simply don't get caught up in really expensive assets, which happen to be doing well now, but they're very overpriced for most other scenarios. So, using valuation to tilt your portfolio to the better opportunities usually results in you losing less and in the long run, making more.
So, those three things are – sticking to your goals and making sure you're achieving the goals; and if you're not achieving them, save more. Secondly, staying the course with a well-diversified portfolio. And thirdly, using valuation to tilt the portfolio to assets that are likely to fall less as well as those which would give you a better return.
JE: Ok. So, that's three tips then on how to successfully navigate during a recession. But I do have a feeling that not all investors tend to stick to the three guidelines. So, what would you say then are the biggest mistakes an investor can do during or even leading up to a recession?
MC: So, what we've just been through in the last 12 months is a really good indicator of some of the things and the traps that we can fall into. We tend to assume that whatever has happened is going to repeat, and if an asset has done particularly well a year or so in the last 12 months, we'll assume it's going to do well going forward.
We had the incidence up until fairly recently of the cryptocurrencies doing really well, being perceived as bulletproof, highly speculative. So, staying away from highly speculative things, or assets that happened to have done well in the last 12 months but have become very expensive. So, that is, not falling in love when things have done really well and have become really expensive is key.
To give you an example, if I go back to 2020, we could see that government bond prices were going up higher and higher as the recession was happening because of Covid-19 and those assets became so expensive that we didn't think they should be in a portfolio. So, we got rid of them. Whereas most investors were clamoring to have them. And sure enough, the returns from those assets tend to be awful afterwards. So, don't go after the darlings that happened to have been doing well in the last 6 to 12 months if they've become expensive.
The second is, don't panic. So, the inclination psychologically is that we really feel the pain of watching the value of our portfolios go down. It feels like we've had a body blow, and the more we pay attention to it, the more we worry about the future and the more we worry about the future, the more we're inclined to say, how can I stop this pain that I'm feeling.
The way we react is by selling out of the investments that we're seeing fall in value. We usually do that after they've fallen in value, so they've already got to the point now where they're offering much better value, but we psychologically (indiscernible) to try and cash out. So, that is something you definitely want to avoid at all costs because you are robbing yourself of the ability to benefit from the rebound that happens. Remember, we talked about recessions don't last forever, and there's an unpredictability about how long they last. So, that's another thing that you want to be mindful of.
And the third thing is, it's easier also to listen to experts who say, yes, it's possible to perfectly time, I can forecast with 100% confidence exactly when the recession will start and when you should get out of markets and then when you can get back in when the recession is almost over. No one is able to effectively forecast those things. You can't perfectly get out at the top and back in at the bottom. So, don't attempt to listen to people who purport to be able to do that. You're better off staying in the course with your strategy and you will come out of that in a much better position than trying to time things.
So, those are really some of the mistakes that people make. Don't get fixated on the investments that have done well in the last 12 months or poorly. For example, bonds have done very poorly in the last 12 months but now offer much better value. Secondly, don't panic and sell out at the bottom. And thirdly, don't think that you can time markets and perfectly get out and get in. You're better off sticking to the strategy that you set out at the beginning, which is designed for you to achieve your long-term investment goals, stick with it. If you need to top up investments along the way and you're able to do that, then that is good, because that will also get those cheaper valuations on your side.
JE: Some great tips for us to take with us in 2023 when we're trying to navigate the market. Thank you so much, Mike, for joining us today. And for Morningstar, I'm Johanna Englundh.
