The threat of something bad happening in the economy is a concern all investors must face. Whether it is recession, inflation or something worse, when the economy suffers investors in the stock market often suffer too.
Economic risk (to investors) can be defined many ways, but broadly speaking it is an umbrella for the risk that your portfolio may suffer as the result of changes in the economy.
The most common problems such as recession or inflation don't happen overnight. It is possible to see in advance the changes in the economy that lead to many problems.
For example, when the economy slows from month to month as measured by the Gross Domestic Product, it can signal a recession is on the way. In times of slow economic growth, consumer spending falls and people are more careful how the spend money.
A common strategy for investors during slow growth is to move assets into non-cyclical stocks that are less affected by lower growth. For example, manufacturers of paper goods (you don't quit buying toilet paper when the economy is sluggish), food producers/distributors (got to eat) and utilities (keep the lights on) often do better in a slow economy that, say retailers that sell non-essential goods.
High unemployment is another drag on the economy. When a lot of people are out of work, consumer spending and confidence wanes. Even people who have a job tend to cut back fearing they may lose their job or have hours cut.
Even if the economy is not doing badly, high unemployment can make investor cautious and the markets wary.
Of course, sometimes extraordinary events come out of nowhere and change the economy and market dramatically. The terrorists attacks of Sept. 11, 2001 are a dramatic example.
There is no way investors could have predicted the attack. Some industries (the airlines, for example) were hurt more than others in the ensuing recession. However, the economy and the market rebounded in due time.
As horrific as that tragedy was, it is the systemic economic problems that cause the most disruption. The housing bubble and corresponding credit crisis beginning in 2008 will be a drain on the economy for years.
How you protect your portfolio from economic risk begins with a judgement of how bad the economy is and whether it is likely to get worse or better.
An important point to remember is that the economy and the stock market are two different things. For example, if the economy takes a dip for several months, it may bring the price of some stocks down and create a buying opportunity for investors willing to take the risk that things won't get too much worse.
No one can predict with any certainty what the market or economy will do in coming months. Signals can point toward probable outcomes, but predicting the future is still a guessing game.
The best defense for most investors is a well-diversified portfolio that does not put too much at risk in any one asset class or industrial sector. In most cases, the long-term investor is better off riding out market slumps rather than jumping in and out in an attempt to avoid losses.
If you are at or near retirement age, you should be especially cautious about relying too heavily on stocks and place more assets in fixed income products.