How A Recession Impacts Your Wealth

Back in August 2019, the 2-Year and 10-Year yield curves inverted, and the clock started ticking….. a recession may be coming.

How Recession Impacts Wealth

Based on historical data, the recession, on average, takes 18-24 months once the inversion occurs. This places the recession to occur sometime in 2021.

How to determine if a recession is coming

I wrote an article previously outlining the different metrics for predicting a recession.

The first way is the inverted yield curve that I mentioned above. Essentially the interest rate on the 2-year Treasury Bond becomes higher than the interest rate on the 10-year Treasury Bond. In other words, the interest rates “invert”.

This metric has predicted the last 7 recessions and 9 of the last 12 overall. While not infallible, the odds of it being accurate are high.

Another way is using the Schiller P/E Ratio. The historical average ratio is approximately 16. Currently the ratio is at approximately 34 and climbing. There has been only a handful of times the ratio has been above 25. In fact, the current ratio is the 2nd highest all-time only topped by the tech bubble of 2000.

A 3rd way is the Wilshire GDP (aka the Buffet Indicator). The market is said to be modestly overvalued if it falls within the range of 90% – 115%. The current ratio is 186%. This means that the total U.S. market capitalization is 1.86 times greater than the gross domestic product of the United States!

The Psychology of the Average Investor

Before we delve into understanding the psychology of the average investor, let’s look at a driver of this behavior: Efficient Market Theory

The efficient market hypothesis (EMH) is a theory which states that it is impossible to “beat the market” because the stock market efficiency causes existing share prices to always reflect all relevant information.

According to the EMH, equities always trade at their fair market value thereby making it impossible for investors to make money off undervalued stocks or sell stocks for inflated prices.

EMH argues that economic bubbles cannot exist because it states that all prices are perfectly efficient and are not undervalued or overvalued. It completely ignores the possibility of an economic bubble that could burst and create an economic crisis.

Proponents of this theory disregarded the possibility of the existence of a bubble. This is one of the reasons that led to the 2008 Recession and the collapse of financial markets as well as the overall collapse of the global economy.

So, if markets are always efficient, how can bubbles occur? How can investors like Warren Buffet make money in the stock market by following the principles of value investing?

The answer is in behavioral finance and people’s tendencies to react in a crisis. Behavioral finance shows that people, in general, are more loss-averse than risk averse. This means that people feel the emotional pain of a loss much more than the pleasure gained from an equal-sized profit.

In order to understand how a recession impacts personal wealth, let’s look at the psychology behind it.

During a recession, the average investor often behaves irrationally and lets emotion get in the way. Behavioral finance tries to explain the emotions people are feeling when investing and how it impacts decision making.

Loss-aversion describes peoples’ tendency to sell winners too early and to hold on to losses for too long. This way they can lock in gains while also avoiding the pain of loss.

When accounts are in the black (making money), people act risk averse. They want to hold onto what they have and avoid the risk of losing it.

When accounts are in the red (losing money), people become risk-seeking. They want to get back what they lost as quickly as possible and are willing to take on bigger and more dangerous risk to do so.

The more important insight from behavioral finance is that stocks can indeed be mispriced. In other words, it’s not always true that a stock price is exactly equal to the true intrinsic value. That’s because investors display biases.

There are typically 5 ways people react to finances (bias) during a recession:

Gambler’s Fallacy

Gambler’s Fallacy consists of misjudging whether a series of events are truly random and independent, and wrongly concluding that the outcome of the next event will be the opposite of the outcomes of the preceding series of events.

For example, a person who believes that because a stock has done well in the past will do well in the future is using gambler’s fallacy.

Confirmation Bias

Confirmation Bias occurs when investors have a bias toward accepting information that confirms their already-held belief in an investment. If information surfaces, investors accept it readily to confirm that they’re correct about their investment decision—even if the information is flawed.

In other words, investors only look for data that supports their belief and ignore data that contradicts it.

Herd Behavior Bias

Herd behavior states the people tend to blindly mimic and follow what other investors are doing. These people are largely influenced by emotion and instinct instead of their own independent analysis. Herd behavior is notorious for being the cause of dramatic stock market rallies and sell-offs.

Overconfidence Bias

Overconfidence bias leads people to overestimate their understanding of financial markets and investing as well as disregard data and expert advice. If on a winning streak, they come to believe their own knowledge and skill as an investor is infallible. It often results in ill-advised attempts to time the market or build a cache’ of potentially risky investments that are considered a “sure thing”.

Availability Bias

Availability bias is the tendency for investors to be strongly influenced by information that is easily prevalent, easily accessed, or a personal perception instead of doing sound financial research. It translates into perceptions colored by personal experiences that only represent a fraction of the complete reality.

In the investment world, investors will choose investments based on information available to them and will not engage in disciplined research or perform the proper due diligence to vet the suitability of a particular investment.

The risk is that decisions may be based more on market perception than facts and real data in the proper context. It can cause investors to make poorly reasoned decisions. Couple this with a stock market dip and wealth accumulation can be severely impacted.

How the Market Dips Impact Wealth Accumulation

We are led to believe that market losses or dips are the natural part of the investment cycle and we need to just “ride it out” and everything will be fine…. or will it?

While market losses happen far less frequently that market gains, the overall portfolio impact is even more extensive.

Here’s an example for you from the book, Rigged by James L. Beatty that I featured a summary on here.

Both Jack and Jill start will an account balance of $100,000.

 Jill earns an uninterrupted annual rate of return of 7.2% each year for the next 10 years. At the end of those 10 years, her account has doubled to $200,000. Not bad, huh? 😊

Jack also earns an annual rate of return of 7.2% for every year EXCEPT 1 year where he experiences a small 5% loss. Guess how much Jack’s account balance was at the end of those 10 years. $195,000? $175,000?… nope. His account balance was $165,000.

You heard it! 1 small market loss and Jill earns about 20% more than Jack did.

How is this possible?

2 words for you: compound interest.    

It’s been called the ninth wonder of the word by Albert Einstein. Most people see it as a blessing and pure magic because people watch how it helps accounts grow and grow.

What people don’t realize is that it can also be a curse because when it works against you (i.e. market losses), the impact is truly devastating.

The worst part about market losses is that while our portfolio balance can recover, the scarring from those losses is felt throughout our entire life.

How is this possible? Here’s another example for you:

In the example above, Jill grew her portfolio to $200,000 over 10 years and Jack’s portfolio grew to only $165,000 over 10 years.

Let’s look ahead to the next 10 years and assume both double their portfolio and here are the results:

Jill has $400,000

Jack has $330,000

Jill still has about 20% more than Jack does! To catch up, Jack’s portfolio must work ALOT harder to recover from that 5% market loss than Jill’s portfolio does…. If it ever recovers.

The $10,000 question is: how to protect our life savings from stock market dips?

How to Protect Yourself

Play Defense First

There is an adage in football: offense sells tickets and defense wins championships. If you want to win the “financial independence championship”, a good defense is a must.

How to develop a good defense?

The first thing is to look for financial instruments that negatively correlate to the stock market. As I discussed in a previous article, things that are negatively correlated with the stock market move in an opposite direction to the stock market. This can help to offset market losses, and depending how allocated, might turn into a gain.

It enables risk to be shifted away from the stock market and balanced out.

Among the potential things to invest in is real estate, private equity, P2P lending, whole life policies, etc.

The more a portfolio is diversified away from the stock market, the greater the chance your portfolio will not suffer from a stock market dip.

Understanding Risk

The biggest lesson to learn about risk is that risk is in the ability of the investor not the investment purchased.

Learn that all you can about investing. Understand what type of investments fit your Investor DNA. If you do not understand it, do not invest in it. Sticking to your strengths reduces overall risk and increases the chances of success.

Don’t know where to start? Use Garrett Gunderson’s Strengthvesting guide as a starting point. I did and it helped me considerably in understanding what fit my particular DNA, and even more importantly, what did not! 😊

Build Up Cash Reserves

As my old accounting professor always implored to us, “Cash is King”. Having a strong cash reserves enables a person to take advantage of opportunities as they come up. It’s always better to buy when things are on sale than when priced at a premium.

I cannot tell you how many “good deals” I spotted that I had to turn down because I didn’t have the cash to invest…. Makes me cringe! GGRRRR! 😊

Wrap Up

A recession is upcoming and inevitable to occur. While no one can predict exactly when it might happen, a person can control how they react to it when it does arrive.

Learn the warning signs, understand basic investor psychology, develop a defensive strategy, and take the necessary action to turn a market loss for others into a portfolio gain for you! 😊

Live the Life You Love, Want, and Deserve! 😊