“Only when the tide goes out do you discover who’s been swimming naked.”
This quote from Warren Buffett – widely described as the world’s most famous investor – describes what happens when a downturn strikes an economy.
In a bull market when everything seems to be rising in value, fortunes can be made quickly or taken to new heights. But in a bear market when the rising tide recedes, only the fittest survive.
With the topsy-turvy nature of economies, it can be tempting to think that money can only be made in good times; that when bad times strike, it’s best to save your capital and wait for the tide to rise again.
But successful investors like Warren Buffett tend to make money no matter what the economic conditions are.
Whether the tide is high or low, savvy investors always seek ways to keep swimming. So let’s explore a few ways of investing in a downturn that could help you keep afloat too.
The stock market is influenced by many factors, but investor confidence plays a large part, and this is in turn a reflection of the health of the overall economy.
So when a downturn hits, stocks take a hit as investors lose confidence and pull their money out.
This can be an opportunity to buy stocks at lower than usual prices – but be careful, just because it’s cheap doesn’t mean it’s good.
During a downturn or recession, Warren Buffett says he buys millions of shares of solid businesses at reasonable prices. Many other traders seek to do the same. But they buy stocks with solid fundamentals, not just cheap ones.
Taking their lead, you could also consider buying shares in companies or sectors that have prospered or at least kept going in bad times because demand for their products or services remained steady.
Another method that you could use to turn the downturn to your advantage is through shorting, also known as short selling.
Essentially, this is where you stake that the price of a stock will fall from a certain level, and pocket the difference if it does.
This can be very profitable, like when a handful of brokers and investment funds famously shorted the US housing market just prior to the 2007 housing market crash and made huge profits.
Be warned though, this is a riskier method than simply buying stocks in sound companies at cheaper prices, and relies on a downturn hitting first, rather than waiting for the slump before acting.
Another way to play the stock market during a downturn instead of buying shares is through investing in options.
An option is a contract allowing the buyer the right (but not the obligation) to buy or sell a certain asset like a stock or index at a specific value on or before an agreed date.
There are two main types of options – a call option and a put option.
Call options buy the right to purchase options from the seller at a predetermined “strike” price. When you buy a put option, the person who sold you the “put” is forced to purchase the particular stock from you at the strike price.
Options are generally considered to be less risky for investors compared to shares because they need less financial commitment.
In a downturn, this could be advantageous as options can allow investors to put their money in play but at a much lower level of intensity.
Another advantage is that options can sometimes deliver higher returns than shares, simply because they are usually cheaper to buy, but can pay off at high rates if the circumstances emerge.
Options are also quite flexible compared to shares, which can be an advantage in a downturn when the market’s overall trajectory is difficult to predict or respond to with certainty.
In a downturn it’s common to see investors pulling their money out of certain shares or financial instruments and sinking it into “sure things” – investments considered safe ground with relatively constant demand and value.
The best example of this is gold, the precious metal whose value tends to shoot up during downturns as investors seek refuge from the carnage in other areas.
This kind of investment is informed by the idea that you should seek long term value rather than short term gain, slow and steady wins the race in other words.
While not as exciting as a tech stock or a risky as a short position, investing in ‘steady’ is a way of parking your money in a downturn with the potential to see a rise in value returned.
Due to their built-in scarcity, some cryptocurrencies are emerging as popular harbours for investors. Their prices do fluctuate, but their limited supply appears to make them attractive to investors.
Another example is classic cars, whose value is widely seen as fundamentally strong. The cars themselves are popular, so they are always in demand, and their value tends to rise, albeit slowly.
Lastly, government bonds – also known as sovereign debt – are securities issued by governments to support their works. They are widely considered low risk instruments because they are issued by authorities, but tend to pay quite low interest rates.
There will always be ups and downs. Know this and plan accordingly.
Because whatever the financial weather throws at them, a good investor should have a number of strategies they can deploy to make money from the markets or at least protect their position.
Shares in recession proof businesses, options, bonds, short positions and eternally valuable things like gold offer a number of different strategies that can be deployed to seek value in the markets, even in a slump.
But in the end, nothing lasts forever whether it’s good times or bad.
If you take a long view of the markets you will see that while the value may rise and fall over the short term, on a long enough timeline good investments tend to rise.