Investing ahead of a recession: 5 mistakes to avoid

It's been a summer to remember for investors, but for all the wrong reasons. The yield curve inverted, trade conflicts intensified and the U.S. economy showed more signs of its age. But just as the summer inevitably turns to fall, investors may be wondering if the economy is moving into its next stage too. Could a recession be on the horizon?

Maybe. Maybe not. Recessions are notoriously difficult to predict, even when signals are starting to flash red. But that doesn't mean investors should do nothing. Since the stock market tends to lead the economy by several months it's often better to be proactive. Late in the economic cycle can be a good time to re-evaluate portfolios, ensuring they are properly balanced and positioned for elevated volatility.

Some may think the best way to prepare portfolios for a recession is to drastically reduce stocks in favor of bonds. The problem with this approach is that it requires a soothsayer-like ability to time the markets. Some of the strongest returns can occur during late stages of an economic cycle and immediately after a market bottom, so being wrong on either turning point can be devastating to long-term returns. A more realistic approach may be to maintain an appropriate balance between equities and fixed income but upgrade the quality of both.

Upgrade your stock portfolio

In volatile markets, investors often tilt their equity portfolios toward value investing and focus more on dividend stocks. This can be an effective way of reducing portfolio risk, but it can also give investors a false sense of security if they don't know what they're buying. Here we highlight three common assumptions often made by investors when they look to increase their value-oriented allocation followed by a suggestion for what may be a better way to upgrade equity portfolios.

Assumption #1: Value investing will always reduce volatility.

Reality: Value indexes can be just as risky as the broader market. Portfolio risk is commonly measured by standard deviation, downside capture ratio and average drawdown. If moving to a value portfolio ahead of expected volatility, you'd want these measures to show lower risk than the overall market. But surprisingly, we see exactly the opposite for both the Russell 1000 Value Index (the most common benchmark for large-cap value investing) and the Morningstar Large Value category (a composite of value-oriented mutual funds) over the last 10 years.

The takeaway? Not all value is created equal. It can be more effective to hold a mix of dividend-paying stocks than a value index.

Assumption #2: Value investing is the same as dividend investing.

Reality: Many stocks in value indexes don't pay dividends. Dividend-paying stocks have tended to hold up better during periods of volatility, so investors may benefit from more dividend exposure ahead of a recession. But don't assume every value fund will make dividends a priority. About 22% of stocks in the Russell 1000 Value Index paid dividends of less than 0.1%, as of December 31, 2018.

Assumption #3: Value investing only includes high-quality companies.

Reality: Low-quality and distressed companies are commonly included in value portfolios. Around 40% of the rated companies in the Russell 1000 Value Index were BBB- or lower (as of December 31, 2018), including many high yielding dividend payers. Companies often appear solid on the surface but carry significant debt burdens and may be on the cusp of losing their investment-grade credit rating. A missed payment or a downgrade could send share prices tumbling, so investors should focus on higher quality companies that are most likely to maintain consistent dividend payments.

What can be done instead?

Investors looking to reduce equity volatility ahead of a recession should consider more rigorous fund screens and not assume that any product with a "value" label will help them achieve their goals. As we see with the Russell 1000 Value Index, even the flagship benchmark for value investing falls short in many ways. Consider a screen that includes funds with the following factors:

• High percentage of dividend-paying stocks
• High percentage of companies with credit ratings of BBB and above
• Low fund-risk metrics, including average drawdown, downside capture ratio and standard deviation

Upgrade your core bond portfolio

Fixed income investments can provide an essential measure of stability and capital preservation, especially when stock markets are volatile. But here too, investors often make assumptions that their portfolios are safer than they really are.

Assumption #4: In a low-rate world, I should reach for yield to get income.

Reality: Reaching for higher yield can be risky. High-yield credit spreads have tightened, and when that has happened in the past credit has significantly lagged U.S. Treasuries. Bond funds with more high-yield exposure also tend to have higher correlations to equity, something investors should avoid in the core bond holdings if they are trying to reduce portfolio volatility.

Assumption #5: Short duration will help reduce volatility.

Reality: Shortening duration probably won't help as the Fed is done hiking rates for now. Investors often turn to short-term bonds for lower interest rate risk, but that is usually most beneficial in a rising-rate environment. Following the Fed's rate cut in July, markets have been pricing in five more rate cuts by the end of 2020.

What can be done instead?

Research firm Morningstar helped simplify bond fund selection earlier this year when it split its largest Intermediate-Term Bond category based on credit risk. Bond funds with less than 5% high-yield exposure were relabeled Intermediate Core, while funds with more now fall into the Intermediate Core-Plus category.

The distinction can be especially important during periods of elevated market volatility, when it's likely you want more core in your portfolio. During the last six equity corrections, the core category had higher returns than core-plus and provided much needed portfolio stability.

Maintain a long-term perspective

Recessions can be painful, but investors who are well prepared and maintain a long-term investment horizon should be comforted that economic declines have been relatively small blips in economic history. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months, with the average recession lasting just under a year. Maintaining a balanced, well-diversified portfolio can help investors avoid the pitfalls of market timing, while being prepared for the relative short-term volatility that comes with recessions. Click here for additional content from Capital Group|American Funds.