There are multiple ways to prepare for a recession ranging from simple such as holding cash, to more advanced and riskier such as short selling. You and I can want to find out ways how to make money in a market crash, and in this post, we will describe the pros and cons of the main assets for that.
Table of Contents
- 1. Cash Reserves
- 2. Gold and Other Commodities
- 3. Short selling
- 4. Put options
- 5. Diversification
- How to prepare for a market crash
- There you have it: the top 5 ways to prepare for a recession and make money in a recession.
1. CASH RESERVES
Warren Buffett is now holding more than half of his holdings in pure cash in the hope of a market downturn, whereas he would be able to scoop magnificent returns by buying supremely cheap as he did in 2008.
The advantage is that it is easy to do and offers tremendous liquidity for you to buy other assets at any time.
The downside of this alternative is that if the market keeps climbing up, he will have missed a substantial amount.
The price you pay for cash reserves is simply the national interest rate you’d otherwise have received by placing in a long-term government bond e.g 20, year Treasury.
Peter Lynch advised against it, saying, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves”.
2. GOLD AND OTHER COMMODITIES
This is my favorite because of its historical strength of being a store hold of wealth and currency reserve.
Gold is an excellent inflation-hedge asset, meaning that the more inflation there is, the more gold should appreciate in value. A recession marked by inflation or by enormous printing of cash, as it is now in the midst of C-19, will invariably inflate gold prices.
See below how gold has compared against currencies since 1850.
Source: Based on Ray Dalio’s book “Basic Principles on Navigating a Debt Crisis.”
As shown, from 1850 until 1971, gold returned (through its appreciation) an amount that equaled the amount of money lost to inflation, with the exception of Germany. However, there were significant variations around that average, such as those previously described (e.g., until the 1930s currency devaluations and the end of World War II devaluations of money that were part of the formation of the Bretton Woods monetary system in 1944).
Gold stayed steady in price while money and credit expanded until 1971. Then in 1971, currencies were devalued and delinked from gold, so there was a shift from a Type 2 monetary system (e.g., notes backed by gold) to a fiat monetary system. That delinking of currencies from gold and going to a fiat monetary system gave central banks the unconstrained ability to create money and credit.
In turn, that led to high inflation and low real interest rates that led to the immense appreciation in the real gold price until 1980–81 when interest rates were raised significantly above the inflation rate, which led currencies to strengthen and gold to fall until 2000.
Other commodities ways to prepare for a recession such as Silver, Platinum, Soya, etc.
If buying gold, it’s better to get physical gold rather than contracts.
3. SHORT SELLING
If you want more than just ways to prepare for a recession, this is for you. Short selling allows you to profit from it.
- Short selling occurs when an investor borrows a security and sells it on the open market, planning to repurchase it later for less money.
- Short sellers bet on and profit from a drop in a security’s price.
- The problem with Short selling is that it has a high risk/reward ratio. Even though you can profit massively, it has no limit to how much you can lose.
Effectively, you are betting against the market. The market tends to increase as assets get more valuable over time and over-perform inflation, exposing you to unlimited losses. However, there’s always a limit to how much they can go down, limiting your profits when short-selling.
For short selling to be effective, you need to be right almost immediately, which rarely happens. Even Michael Burry in the Big Short movie didn’t actually short sell but used put options credit swaps that will be explained in the next point.
4. PUT OPTIONS
Used by most hedge funds to hedge their positions, long and call puts are standard practices amongst advanced investors. In 2020, Ray Dalio from Bridgewater Associates used against the European market in March and benefited profitably. Bill Ackman also used against the C-19 environment. Michael Burry during the 08 crisis and Warren Buffett (yes, he does it too) since 2006.
A put option allows you to sell stock through the expiration date at a given price. If you pick a strike price above the current price, you buy a put option that is in the money (ITM). The opposite would be considered an out-of-the-money option (OTM).
The deeper you buy an ITM put, the less leverage you are using because the price of the option will be greater. The opposite is true the farther the option is OTM. If you think the stock could make a big down move but don’t want to short it, buying a put option can be used.
There is one non-leverage reason for buying a put option. You like the long-term outlook of a holding but want to protect against a pending drop.
Pro: Unlike any other strategy, you have total control over the amount of leverage used and the level of risk taken. It also allows for the slightest use of leverage in terms of dollars invested.
Cons: If you write uncovered calls, your risk is unlimited. Also, unlike the other strategies that can be timeless, your investment has to “pay off” within the time frame you chose to buy/sell your option for.
5. DIVERSIFICATION
Lastly, consider that diversification is the best way to prepare for a recession. Never keep all your eggs in one basket, and try to spread your investments across several markets.
For example, most experts advise us not to place more than 5% of our funds in commodities unless we have a specific strategy, and preferred stocks shouldn’t make up most of anyone’s portfolio.
As you explained, you can never fully predict a market crash or recession, but you can prepare. You and I want to know how to make money in a market crash, but it is more complex. We need to adjust our portfolio percentages according to our reading of market cycles.
When things are “hot”, we should be transitioning parts of our portfolio from developing into developed markets, from growth into value stocks, from real estate into commodities and gold, and from the leveraged position into cash. It is a balancing act with no set-in-stone percentages.