The subprime mortgage mess has raised the odds that the economy, growing since 2001, might slip into a recession. Economists at Merrill Lynch, for instance, think there is a 65 percent chance of a downturn. The pros at Charles Schwab estimate the odds of a recession over the next 12 to 18 months to be higher than 50 percent. If they're right, you can be sure the stock market will take a bruising tumble as well.
Focus on staples. People buy household products and healthcare regardless of how much they're hurting financially, says Christine Benz, director of mutual fund analysis at Morningstar. That means companies such as Procter & Gamble, Kellogg, General Mills, and Johnson & Johnson are still good bets. "Those are areas traditionally thought to be recessionproof," she says. On the other hand, companies responsible for discretionary items, such as Ford or GM, are more vulnerable.
Benz also suggests focusing on larger companies with more diverse product lines because they will be more insulated from market swings. In the recessionary year 1990, for example, the Russell 2000 index, which is composed of small-cap stocks, lost 20 percent, compared with the S&P 500, which lost only 3 percent.
Shift into bonds. "Money markets and short-duration bonds do very well in bad capital markets," says Fran Kinniry, principal in Vanguard's investing counseling and research. Vanguard's Prime Money Market Fund, for example, currently yields 5.11 percent. He points out, though, that if the Federal Reserve responds to a downturn by lowering interest rates, those yields will go down, and riskier assets such as stocks will begin to do better.
Take home cash. "Think about building your personal reserves in case you were to lose your own job," advises Benz. Savings accounts or money market funds are safe places to store money. While you won't be exposed to any upswing in the markets, Benz suggests tucking away at least three to six months of living expenses.
Divide your portfolio into tiers. John Girouard, author of The Ten Truths of Wealth Creation, suggests dividing your money into three groups, depending on how soon you need it. The size of each one will vary by person, depending on financial goals and age. The first group should be in investments protected from market instability, such as money market funds and savings accounts, which pay around 4 to 5 percent a year. That money is available for immediate spending. The second, which contains money you plan to use after five years, should be divided relatively evenly into stocks and bonds. And the third, which you plan to use after 10 years, should consist mostly of stocks. "You've got to layer your investment portfolio," he says, to make sure the money you need tomorrow isn't threatened by market cycles.
Use target funds. "Creating a well-diversified portfolio, with age-appropriate allocations, historically has been the best way to reduce the risk of short-term market volatility," says Deborah Pont, a spokeswoman for Fidelity. Fidelity Freedom funds, which shift their allocations into more conservative investments as investors age, do just that, says Pont.
Don't do anything. If your portfolio is as diversified as it should be, then downturns should inspire only slight adjustments, if anything, says Brad Sorensen, director of sector research at Charles Schwab. Investors, he says, might want to move 1 or 2 percentage points of their portfolio into the healthcare sector and out of the consumer discretionary sector, for example, but keep their core portfolio constant.
Moving too much into safer places, such as cash or bonds, could mean losing out on unexpected gains. "If the Fed comes in and aggressively cuts rates, we could have a huge rally," says Sorenson.