How to Prepare for a Recession
It can happen suddenly and seemingly without warning. One minute the U.S. economy is chugging along swimmingly. Then an event like COVID-19 happens, plunging the world into a crisis and ushering in an economic recession.
A recession can be one of the most difficult financial situations to work through — especially if you’re unprepared as an investor and are bad at budgeting.
However, it can also be a once in a lifetime opportunity to make money if you manage your funds properly. It all depends on how you prepare ahead of time.
What is a Recession?
As economists will tell you, a recession is like a massive injury to an economy. In short, it’s a prolonged period of significant decline, during which there is limited industrial activity due to rapid job loss, widespread unemployment, and lower gross domestic product (GDP) output.
When a recession hits, most parts of the economy can still operate even though a lot of economic activity dies down. Supply chains can still move and businesses can remain open, but the overall output is much less than normal.
As a result, markets and investments can drop significantly in value during a recession — just like we saw during the Great Recession. If you’re investing in the stock market during a recession, you will likely experience a sharp drop in your portfolio.
But don’t give up. If history teaches us anything, it’s only temporary, and economic growth is lurking somewhere around the corner.
Is a Recession the Same as a Depression?
If a recession is like an injury to the economy, a depression is a critical trauma. A depression is an extreme recession that goes on for three or more years and leads to a GDP decline of at least 10%. We all remember from our history books how bad things were during the Great Depression.
As you can see, depressions are more severe than recessions, and their implications can affect entire generations.
Key Financial Lessons from the Coronavirus Pandemic
The U.S. fell into an economic recession following the outbreak of COVID-19 early in 2020, when widespread shutdowns led to reduced total economic output. This, in turn, ended the record-breaking period of economic expansion that the country had been riding since 2009.
Toward the end of 2020, many economic signs pointed to a recovery, though it remains unclear what is ahead. Regardless of what happens in 2021, it’s clear that investors need to be prepared for anything.
Whether the economy comes roaring back or we slide back into a recession, here are some key financial lessons to learn from COVID-19.
It’s Crucial to Have an Emergency Fund
Not everyone thinks to set up an emergency fund. However, emergencies happen when you least expect them, whether it’s an extended hospital stay, a lost job, or a global pandemic. The more prepared you are, the easier it is to survive one.
Generally speaking, you should set up an emergency fund to cover at least six months of rent or mortgage payments, utilities, food, student loans, and credit card payments. A months’ worth of savings just won’t cut it in today’s unpredictable economic landscape.
Avoid Credit Card Debt
Managing bad credit card debt is difficult enough during times of health and prosperity. During a recession, it can become seemingly impossible.
Unfortunately, credit card companies are unsympathetic during events like recessions and pandemics. In other words, you’ll still be expected to make your payments on time, even if you’ve lost your full-time job.
The best thing that an investor can do is avoid credit card debt altogether. That’s not to say you shouldn’t use your credit card, as it’s a great way to build credit over time and it’s a lot more convenient than paying with cash.
However, you should always make sure to pay down your debt with each monthly statement. Otherwise, you could wind up struggling to pay down balances by incurring hefty interest charges.
Have Multiple Sources of Income
A recession can put a lot of strain on businesses, leading to budget cuts and layoffs. Unfortunately workers — especially higher-paid employees — are often the first ones to feel the brunt of a downturn.
The best way to protect yourself against a market downturn is to plan ahead and have multiple sources of income. Starting a side hustle is a great way to bring in extra income and plan for a potential downturn.
How Many Sources of Income Should You Have?
This largely depends on your personal situation — including your skillset, industry, and work arrangement. For example, not all businesses allow their customers to have side hustles. If you’re in a position to start a side hustle, look for as many opportunities as you can.
In today’s fast-moving and unpredictable economic environment, it’s not uncommon for workers to have five or six sources of income. This could mean the difference between bringing in $2,000 per month or $10,000 per month.
Stock Up on Necessities
When COVID-19 broke out, there was a massive shortage of specific products. Grocery stores quickly ran out of items like toilet paper, bottled water, and hand sanitizer. In some places, prices for valuable commodities skyrocketed abruptly.
If you have ample storage, consider stocking up on nonperishable items during times of economic prosperity so that you don’t get caught off guard due to product shortages or rate hikes. It pays to plan ahead for emergencies when you can.
Building a Financial Strategy to Handle the Next Recession
Market downturns are inevitable. Unfortunately, there is nothing that investors can do to prevent them. However, there are certain things that you can do to mitigate the damage.
Prepare a Recession-Proof Portfolio
One of the hardest things to deal with when investing is exposing yourself to market volatility. The fact is that the stock market is unpredictable. Sometimes, the market is up and sometimes the market is down, and there’s not always an explainable, rational reason behind it. And during a recession, the market stays down for a prolonged period of time — months, or even years.
Talk to a financial advisor to assess your risk tolerance so that you can understand how to prepare your portfolio to handle periodic downturns. There are certain types of investments that you can make to protect your assets, such as index funds or ETFs.
Additionally, a diversified portfolio will help you weather the worst of the storms. If you owned shares of airlines and cruise companies heading into the pandemic, for example, your portfolio took a substantial hit. But if you also owned shares of tech companies that were able to benefit from, say, lots more people working from home, that would have balanced out the losses from the travel sector. As the saying goes, don’t put all your eggs in one basket.
Creating a solid financial plan during prosperous times can help create a roadmap for navigating a recession.
Reassess Your Budget
Take a hard look at your budget and living expenses and figure out whether you are spending beyond your means. If you are consistently dishing out more than you bring in every month, it may be time to make some lifestyle changes.
Chances are there are luxury items you are paying for that you can easily do away with by being more frugal. For example, think of that Netflix account that you are paying $20 per month for. Are you really getting the most out of Amazon Prime? Or, maybe you are spending too much at the grocery store. And that gym membership that you haven’t accessed in a year? That could probably go, too. After all, you don’t need to spend money to run around the block or do home exercises.
Look for New Ways to Generate Income
Since you’re reading these words, you’re obviously interested in doing what you can to protect your financial future. So why not spend some time trying to come up with a few extra ways to generate income?
Keep in mind that your paycheck is still your most precious asset. It’s responsible for paying your bills and funding all of your investments. Without cash coming in, it’s difficult to do many things in life.
This all begs the question: What can you do to bring in money? For example, if you have a lawnmower, maybe you can take care of your neighbors’ lawns. If you know how to cook, you may be able to have friends or family members pay you to make meals a few nights a week. You might even be able to clean houses once or twice a month for extra cash.
Any part-time job can help to advance your position and build a financial cushion for your future.
A downturn can push you beyond your comfort zone and cause you to work harder than you normally would. But if you start up a side hustle before a downturn occurs, you won’t be caught off guard when the economy takes a turn for the worse.
Learn New Skills
When analyzing your personal financial situation prior to a downturn, you may not like what you see. This can be a tough pill to swallow. However, the truth is that you may not be fully prepared to handle catastrophic events like a pandemic.
For example, you may find that you are in a position where you’re making more money than you probably should while offering limited value to your company. If that hits too close to home, you might be a sitting duck for the next round of layoffs.
If this is the case, consider learning new skills during a downturn by going back to school or taking a course to advance yourself. Make a conscious effort to improve your situation and bring more value to the table.
At the same time, you should brush up your resume and start putting feelers out for new jobs ahead of time. That way, if something happens to your job, you’ll have a leg up on the competition and potentially reduce the amount of time you spend unemployed. Don’t underestimate the value of networking.
These are some of the most common questions I’m asked about managing money during a recession.
How long do recessions last?
Recessions typically don’t last very long. In most cases, they come and go within eight to 18 months.
As such, it’s important to avoid panicking during a recession — especially with financial planning. The best way to plan for a recession is to build a strategy that enables you to weather the storm and escape with minimal damage.
What should you buy during a recession if you have extra money?
If you have cash on hand and are in a position to buy securities during a recession, you might be able to buy stocks “on sale.” Going back to the earlier example, if you think that airlines will eventually recover to their full, pre-pandemic value, shares of some of those companies are in the bargain bin.
Or, if you have a lower risk tolerance, you can invest in the companies that are likely to ride out any downturn. People will always need to buy the staples and other things they need (not want), and they’ll probably get them companies like Amazon, Target, Home Depot, and Costco.
A lot of investors try to outsmart the market for short-term wins — buying shares of vaccine makers they read about in the headlines so they can ride that bump. Keep in mind that there are likely a lot of people and institutions who know a lot more about the pharmaceutical industry than you do. If you’re basing your investing on the news headlines, you’re probably late to the party. Better to buy great companies that you think will be thriving a decade down the road.
Just remember to research your investments thoroughly and avoid doing anything hasty. And before you sell any securities, understand how you may be impacted by capital gains taxes or brokerage fees.
What does it mean to hold on for dear life?
Holding on for dear life refers to an investment strategy that involves keeping investments and riding them out through downturns — even when they lose money.
The reason for doing this is that the long-term projection of a stock or fund could be more valuable than its current performance indicates. This is especially true with index funds, which are known for dropping in value and then rebounding and reaching a higher peak.
Keep in mind that it takes a significant amount of data and insight — and impeccable timing — to make an informed financial decision and sell at a gain when timing the market. Most experts would agree that you’re likely to wind up regretting your decision if you try to time the market. The best investors tend to hold on to their investments unless they need the money, see a better opportunity elsewhere, or their investment thesis has changed.
What is a high-yield savings account?
A high-yield savings account (HYSA) is a type of savings account that offers relatively high interest returns along with the security of a savings account.
One thing to keep in mind about using an HYSA account is that while you can’t lose money during a downturn, you can still receive a lower interest rate. That’s because HYSA interest rates are variable and fluctuate based on the state of the economy. When the Federal Reserve cuts interest rates, yields drop — meaning you’ll get less back on a monthly basis.
If you want to avoid changing interest rates, consider locking your money up in a certificate of deposit (CD). This is a secure way to maintain a higher interest rate throughout a recession. The only caveat is you might not be able to touch your money until it matures unless you’re willing to pay a penalty.
The Bottom Line
Economic downturns aren’t worth stressing about. Much like the weather, the market changes from time to time. If you stress about things like downturns, you are bound to be miserable. If your investments are keeping you up at night, you’re doing it wrong. Don’t invest money you might need in the next five or so years and don’t invest money that you’re not willing to lose.
The best thing to do is to build a sound financial strategy that can get you through tough times relatively unscathed. In fact, if you play your cards right, you can even profit during a downturn. Plenty of investors have gotten rich over the years by being in a position to buy when stocks tumble and knowing where to put their money.
Now is the time to start planning for the next recession. Know how markets work, know how to protect yourself, and you should be fine in the long run.
However, if you make hasty decisions based on fluctuating market conditions, you will most likely regret your decisions down the road.
Take my word for it. I’ve learned the hard way before. Let’s hope you don’t have to as well.