What is a recession and how it affects investing
Guide Summary
- A recession is a period of declining economic activity, often triggered by factors like inflation, high interest rates, or external shocks.
- While market downturns can be unsettling, recessions are part of the normal economic cycle and may present investment opportunities.
- Investors can prepare by diversifying, staying focused on long-term goals, and understanding how different assets behave during a downturn.
What is a recession?
A recession is a significant decline in economic activity across the economy, lasting more than a few months. In the UK, it is commonly defined as two consecutive quarters of negative GDP (Gross Domestic Product) growth.
Recessions affect many areas of the economy such as employment, business profits and consumer confidence. While often seen as negative, they are a natural part of the business cycle and can set the stage for future growth.
What causes a recession to happen?
Several factors can contribute to a recession. These factors can include:
- High inflation: When prices rise too quickly, consumer spending can fall, slowing the economy.
- High interest rates: To combat inflation, central banks (like the Bank of England), may raise interest rates, which increases borrowing costs for businesses and households.
- Falling consumer confidence: When people become uncertain about the future, they tend to spend and invest less.
- External shocks: Events like global pandemics, geopolitical conflicts, or oil price spikes can disrupt economic activity.
- Financial market imbalances: Asset bubbles (rapid price rise above value) or debt crises can lead to sudden market corrections (a drop of more than 10% in an index's market value) that can ripple through the broader economy.
Often, it’s not one cause but a combination of several factors that can lead to a downturn at various stages of a recession.
How long do recessions last?
The length of an economic recession varies. Historically, UK recessions have lasted anywhere from a few quarters to several years. For example, the 2008 global financial crisis caused a recession that lasted around five quarters in the UK.
However, economic recovery often begins before people realise, as confidence and spending start to pick up.
How does a recession affect investing?
Given how recessions have an immediate impact on the economy, a recession can affect various investment asset classes, including:
- Stock market volatility: Share prices often fall as company earnings decline and investor sentiment weakens.
- Bond markets: Government bonds may become more attractive as investors seek safer assets.
- Dividend cuts: Companies may reduce or suspend dividends to conserve cash.
- Property market: Housing prices may fall due to reduced demand and tighter credit conditions.
- Currency fluctuations: For example, the pound may weaken, especially if the UK economy is underperforming compared to others.
For investors, a recession can bring short-term losses, but it also creates long-term opportunities, particularly for those who remain calm and strategic. Understand investment risks and strategies.
How can investors prepare for a recession?
Preparation is key. There are various investment strategies investors can take into account. This includes:
- Review your risk tolerance: Make sure you review the amount of loss you’re prepared to handle while making an investment decision.
- Diversify: Spread investments across different asset classes and sectors to reduce exposure to any single area.
- Maintain an emergency fund: Cash reserves help cover living expenses without needing to sell investments during downturns.
- Focus on quality: Strong companies with strong fundamentals and healthy balance sheets are more likely to survive and recover.
Avoid trying to predict the exact timing of a recession. Instead, focus on building a resilient portfolio that can weather a range of outcomes.
How to invest during a recession?
Investing during a recession can feel counterintuitive, but it can also be a time of opportunity.
- Stay invested: Attempting to time the market often leads to missed gains when markets rebound.
- Look for undervalued assets: Prices may fall below their true value, offering long-term potential.
- Use pound-cost averaging: Regularly investing a fixed amount can help smooth out price volatility over time.
Remember, recessions don’t last forever. Markets typically begin recovering before the wider economy does.
What are the risks of investing during a recession?
A recession brings economic uncertainty. For investors, it’s important to understand potential downsides:
- Increased volatility: Markets can swing widely in either direction. Learn about stock market basics.
- Company defaults: Some businesses may not survive, particularly those with high debt levels.
- Lower income: Investors relying on dividends or interest may see reduced payouts.
Risk cannot be avoided entirely, but it can be managed through careful planning, diversification and understanding the risks involved.
Recession and investing summary
Recessions are challenging, but not unusual. For new investors, understanding how they work, and how markets tend to react, is a key part of building confidence and resilience.
By focusing on long-term goals and maintaining a diversified, risk-aware strategy, it’s possible to navigate economic downturns more effectively.
Up next, learn what liquidity is and how it can affect investors.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation.
