Recession-proof your investment portfolio

Here is February's Investing Tip of the Month, brought to you by Morningstar Investment Research Center ...

There's lots of talk of a recession these days, making many investors nervous. What exactly is a recession? The technical definition is two quarters (six months) of negative gross domestic product growth. (GDP is the total market value of the new goods and services produced during a specified time span.) More simply, a recession describes a shrinking economy rather than a growing one.

Although a downturn in market performance isn't necessarily a recession, the two can go hand in hand, as the last two recessions in 1990 and 2001 suggest. Currently there's not a consensus on whether the U.S. economy is already in a recession, heading for a recession, or simply slowing down, but it never hurts to be ready. Below are a few important steps to take when the economy turns sour.

Buy, Don't Sell
We all know the old adage "Buy low, sell high." Yet that's the opposite of what some people do when the economic climate looks gloomy. The start of a recession is not the time to liquidate your investments. Depending on your time horizon, you most likely have enough time to ride out short-term stock price drops that might happen during a recession. If you're in your 30s and saving for retirement, a few market bumps will be ironed out in the long run. Still, it's important to construct your portfolio with your time horizon and risk tolerance in mind, which can help you sleep easy if the market continues to tumble.

A recessionary environment could even be a time to increase your contributions to your portfolio. Some mutual fund managers, particularly those who are attentive to valuation, have told us they've found bargains amid the market's recent volatility. For example, the team at Longleaf Partners urged current investors to consider adding more to their holdings because it's finding a lot to buy right now, and it also opened the fund to new shareholders after being closed since July 2004. By continuously contributing to your portfolio, you'll participate in purchasing those deals.

Stay the Course with Dollar-Cost Averaging
With uncertainty in the air, it can be tough to stay disciplined about investing. Therefore it's a good idea to set accounts on autopilot in order to avoid the temptation of hoarding cash under your mattress.

Most investors in 401(k) plans make contributions on a regular basis; you might also consider doing so with your other accounts. Dollar-cost averaging, or investing a set amount of money at regular intervals, can also help bolster your savings when the economy starts growing again. For example, say you invest $500 a month in a mutual fund. The fund's shares are worth $10 apiece initially, meaning you can purchase 50 shares a month. If the underlying assets appreciate a total of 20%, and now the fund's NAV is at $12, you purchase fewer than 42 shares that month. But if the fund's NAV drops 20% to $8 a share, your $500 will purchase almost 63 shares. Therefore, consistent dollar-cost averaging can result in a lower overall price you pay for shares; it will also ensure that you don't lose your resolve to invest amid market turbulence.

Saving Matters
Unemployment can skyrocket when economic growth slows. Losing your job is a huge financial blow. Regardless of what the economy is doing, you should prepare for the worst by saving three- to six-months' worth of living expenses in an emergency fund. It's best to store the money in a very liquid account like a money market fund, which isn't usually subject to price drops and generally pays more interest than a regular checking or savings account.

Check Your Diversification
Still worried? Take some time to make sure your portfolio is well-diversified. A good place to start is Morningstar Investment Center's Portfolio X-Ray tool. There you can see your portfolio's exposure to different asset classes, sectors, and world regions. In a recessionary market, it's a good rule of thumb to make sure your portfolio includes exposure to companies that should thrive in a depressed environment, such as health care and consumer staples. People need to buy food and take their medicine regardless of what the economy is doing. Exposure to foreign stocks could also be a good defense if the U.S. is the primary economy hit by a slowdown. On the flip side, you'll want to make sure your portfolio doesn't have too much allocated to cyclical sectors such as industrial materials, media, and consumer services.

Likewise, make sure your fixed-income allocation is skewed more toward high-quality bonds rather than their junkier counterparts. When the economy hits the skids, prices on bonds of lower credit quality can precipitously drop, and make a serious dent in your savings. Yet those funds holding bonds with the highest credit quality can benefit from investors looking for a safer haven. You can investigate the overall credit quality of your bond holdings using Instant X-Ray by clicking on the Bond Style tab in the drop-down menu.

Morningstar Investment Research Center is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.