Investors should always hope for the best and plan for the worst. That means a healthy dose of diversification.
The COVID-19 pandemic has disrupted lives and economies around the world, and the volatility in equities markets reflects this. Some investors may believe the recent uptick in stocks shows that economies are poised to recover quickly once the pandemic ends. After all, most U.S. indices are up by more than 30% in June since bottoming out in mid-March.1 Yet there are huge uncertainties about the course of the virus and what a full economic recovery might look like. In this environment, smart investors know to hope for the best and plan for the worst. That means sticking with the basic principle of diversification and making sure they have holdings across a variety of asset classes.
Even before the pandemic hit, some experts were arguing that investors should be wary of overweighting stocks in their portfolio. After a record-long bull market, including strong gains across most U.S. indices in 2019, most stocks were at record highs. However, no bull run lasts forever, and several foreign indices that peaked before a recession still have not recovered more than a decade later.2
The economic disruptions from COVID-19 have compounded those concerns. The sheer scope of the contraction has been unprecedented, and a full recovery could take years.
From mid-March to late May, 38.4 million people in the U.S. lost their jobs, pushing unemployment rates to Great-Depression levels. Some economists believe a good portion of those jobs will not return even after the pandemic is over, in that some companies may not recover, and even those that do may not return to pre-crisis employment levels.3
SOURCE: “U.S. Bureau of Labor Statistics,” tradingeconomics.com, accessed July 6, 2020.
There are other factors to consider. According to The National Bureau of Economic Research, we entered a recession in February 2020. The recession marks significant declines in economic activity across production, employment, and other indicators.4
The U.S. Purchasing Manager’s Index (PMI), a metric of economic trends in manufacturing, plummeted in response to COVID-19. April marked the fastest rate of contraction since the global financial crisis. June saw a modest reversal of the downward trajectory.5 But with fresh spikes of COVID-19, the numbers could decline again as part of a W-shaped recovery.
Some optimists have looked back to the 1918 Spanish Flu pandemic as a precedent. The recession caused by that event was relatively mild, and the recovery was quick. But the U.S. economy is dramatically different today, with far more people working in service industries and fewer people in agriculture or manufacturing jobs. Service occupations are likely to see a longer impact from the COVID-19 pandemic, because they require face-to-face interactions, and customers are unlikely to return until they feel it’s safe.6
That ties to a much larger point: About two-thirds of economic activity worldwide comes from consumer spending—people eating out, booking trips, buying home goods, and making dozens of other discretionary purchases. High unemployment will stifle that spending—when people don’t have paychecks, they can’t spend—but a lack of consumer confidence due to physical safety and economic uncertainty will put the brakes on any recovery as well. And consumer confidence issues could last for years.7
To be clear, some upsides could factor in. The U.S. government has already invested heavily in stimulus measures to cushion some of the worst impacts of the slowdown, and more spending could be coming. The course of the virus is a huge unknown as well—it could ease, a vaccine could be developed, or countries could develop the right level of herd immunity.
But that is a significant amount of uncertainty, and smart investors realize they can’t possibly manage it all or predict the future. Instead, they need a portfolio built for both positive and negative economies. To that end, they can diversify across asset classes—not just stocks and bonds but also non-traded alternatives.
Diversification may help tamp down volatility by spreading risk across assets that have different risk levels and potential returns, potentially giving investors exposure to different parts of the economy. Of course, diversification can’t guarantee that a portfolio won’t experience losses. But some research has found that diversification, when positioned correctly, can help investors reduce risk without sacrificing returns.8 As always, there is no guarantee that diversification reduces risks, for example if the investors adds high risk investments to their portfolio.
But in the current market, with so many warning signs flashing about a potentially long and painful recovery, diversifying across assets and staying invested for the long haul may be a solid strategy for investors to prepare their portfolios so they are ready.
1 “S&P 500, Dow Jones Industrial Average & NASDAQ Indices,” Yahoo! Finance, Yahoo!, accessed June 7, 2020.
2 Julia La Roche, “Jeffrey Gundlach: The US stock market ‘will get crushed’ in the next recession.” Yahoo! Finance, Yahoo!, Dec. 2, 2019.
3 Patricia Cohen, “Many Jobs May Vanish Forever as Layoffs Mount,” New York Times, May 21, 2020.
4 Determination of the February 2020 Peak in US Economic Activity, National Bureau of Economic Research, June 8, 2020.
5 “United States ISM Purchasing Managers Index (PMI),” Tradingeconomics.com, May 2020.
6 Brian Asquith and John Austin, “What Can the Past Teach Us About a Coronavirus Economic Recovery?” Barron’s, May 21, 2020.
7 Peter S. Goodman, “Why the Global Recession Could Last a Long Time,” New York Times, April 1, 2020.
8 Coryanne Hicks, “Why Diversification Is Important in Investing,” U.S. News & World Report, Sept. 27, 2019.
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