The most important takeaway is that you prepare for a recession just like you prepare your finances at any time: build a solid foundation, invest appropriately for your goals, and stay on plan.
First off, let’s set things straight on what a recession is. A recession is a period of economic contraction amounting to more than a few months of negative economic growth. That means that when the country’s total economic output as measured by its gross domestic product (GDP) shrinks (usually by at least two consecutive calendar quarters), we’re in a recession.
A recession is different than a drop in the stock market, but recessions are generally accompanied by a market decline. That’s because stock values tend to decline when near-term corporate profits decline, something that happens when economic growth slows down. In addition, investors generally become wary of declines and tend to sell stocks and buy bonds in an effort to protect their portfolios. This selling pressure also tends to push stock prices down.
Recessions are also correlated with increasing unemployment. Businesses, concerned about weak demand and keeping profits up may lay off workers or curtail hiring plans. Periods of higher unemployment tend to follow recessions and may persist even after the economy has returned to growth. High unemployment can feed into weak demand and median incomes tend to fall as well.
Lower growth, a weaker stock market, and high unemployment can be a scary prospect, but there are actions you can take to protect yourself and your family.
First off, make sure your foundation is sound by building an emergency fund, eliminating high interest debt, building job security, and if possible diversifying your income.
Building an emergency fund is step one. To weather any sort of financial storm, you want enough funds set aside to cover your expenses should you lose the income you count on to pay for them. At a minimum, you want to build up a cushion of three months worth of expenses before beginning to save elsewhere, and we recommend six months to provide more comfort for you and your family in trying times.
Eliminating your high interest debt frees up cash should you need to hunker down as well. Not only are you getting a solid return on any savings applied to this debt, but you’re also creating room to cover future emergencies as well.
After the financial basics, bolstering your job security is next on the list. Most people depend on a steady stream of income for their lifestyle and it can take time to replace that stream if it’s lost, especially in a downturn. The more valuable you make yourself at work, the less likely you are to find your income at risk, and the more likely you are to increase that income stream going forward.
Finally, consider diversifying your income. If you have the time and the inclination to build additional income streams - from consulting work, passion projects, hobbies, or even second jobs - you have something to fall back on should your primary income become threatened. Let’s be honest though, not many people have a ton of free time so it’s understandable if this is further down your list or off it entirely.
Once you have your financial foundation in place, you need to make sure that your savings are invested appropriately. Each of your accounts should have a specific goal associated with it, and each of those goals should have a risk profile associated with the goal’s time horizon and your own risk tolerance.
The key thing here is to avoid trying to time the market. No one can predict what the market will do tomorrow, a month from now, or next year, so your strategy should be focused on your goals and when you might need your invested money. Investing conservatively for your near term goals ensures that your funds remain more stable and that the effects of market movements are dampened. Likewise, investing aggressively for your long term goals is appropriate because you can weather the effects of the market’s ups and downs without having to withdraw in a down environment.
That brings us to our last point: stay the course. Stay invested when you see the market take a dive. This is probably the hardest part of dealing with a recession. Imagine: you’ve just seen your portfolio take a hit, you feel farther away than ever from financial freedom, and there’s nothing but doom and gloom in the media, and you’re asked to stay invested in the market? That’s a tough sell, but it’s the best advice we can provide.
Here’s why. Your near-term assets should see only a modest hit because they’re invested conservatively. That’s why you traded higher potential returns for lower risk, so you can use these funds whenever you need them. Your long-term assets are going to see a hit because they’re invested for the long-term. You won’t need these funds immediately, which means that they can stay invested in the market and benefit from the post-recession rally.
We’ll take this even farther: you should save and invest as much as possible in a down market because you’re buying assets when they are the cheapest. You still cannot time the market, but continuing to invest throughout the downturn means that you’re buying as assets become cheaper, at their cheapest, and on the rally.
Getting through a recession can be financially and psychologically draining, but by preparing appropriately, investing according to your goals, and staying the course as the recession continues, you set yourself up to come out in good shape on the other side.