What Is a Recession Exactly?
A recession is a slowdown in economic growth that’s significant enough to affect employment, manufacturing, retail sales, gross domestic product, and consumer income. The National Bureau of Economic Research (NBER) officially defines when recessions begin and end based on changes in measures including unemployment, income, and industrial output. But most people simply notice difficult economic conditions. You might see slower earnings growth, more frequent job losses among those around you, and other headwinds that affect your financial goals. But with the tips below, you can improve your chances of emerging from the next recession in decent financial shape.
Build Savings
If you don’t already have a healthy emergency fund, building one is the first step you should take to shore up your defenses against a downturn. A rule of thumb for emergency savings is to keep three to six months’ worth of expenses in cash. This could help you get through a period of unemployment if you lose your job. There are some circumstances in which in makes sense to squirrel away even more. If you’re at a senior level in your career, it could take you longer to find a new job than someone who’s more junior. Also, if you have high fixed expenses like a big mortgage, it could make sense to build a bigger emergency fund. However, if that seems impossible, just start with what you can afford and add to it from there.
Reassess Your Budget
In order to build that emergency fund, you may need to examine your spending. It’s always wise to monitor your spending, and that’s especially important during hard times. “Make sure each dollar is accounted for and has a purpose,” Jovan Johnson, a certified financial planner (CFP) at Piece of Wealth Planning, told The Balance by email. That’s something you can accomplish with a zero-based budget, which promotes intentional spending. When you plan your spending carefully, every dollar of income goes toward a specific expense. For example, you anticipate spending for categories such as housing, food, loan payments, and utilities. But what happens if you earn more than you spend on bills? You add additional categories for saving (emergency fund, retirement savings, vacation fund, and so on). As a result, you’re less likely to spend money on luxuries that might prevent you from meeting financial goals. Eric Roberge, CFP at Beyond Your Hammock, told The Balance by email that now is the time to take action on your spending plan; don’t wait until a recession is in progress. By getting proactive, you can free up cash flow to build that rainy-day fund. To accomplish that, you may want to hold off on major purchases, cut unnecessary spending, and focus on needs over wants, said Roberge.
Pay Down High-Interest Debt
Another way to get prepared for a recession is to pay down—or eliminate—debt. Doing so can reduce your monthly obligations, making it easier to absorb any speed bumps you hit during a recession. For example, if you lose your job or work fewer hours in a slow economy, life will be easier with fewer or lower monthly payments. But be strategic when paying down debts. Debts with high interest rates, such as credit card bills, should take priority. And if you don’t have an emergency fund yet, building up those savings might make more sense than aggressively paying down debt, said Johnson. “If there is an adequate emergency fund set in place, it may make sense to pay down credit card debt,” Johnson said. But if you put all of your free cash flow toward debts, you may be unprepared for surprises—and having a cushion of cash could be valuable in a recession. That said, once your cash-flow situation is secure, Johnson favors prioritizing high-interest-rate debt payoff.
Focus Your Investments for the Long Term
Should you change your investment strategy to sidestep potential losses related to a recession? “The short answer to this is no—assuming you have a sound investment strategy that is designed for the long term,” Roberge said, Trying to time the market by selecting recession-friendly investments may be frustrating and risky. You might be better off with a long-term strategy designed for all types of conditions—including recessions. When you use that approach, you don’t need to take action in anticipation of recessions because your plan already accounts for the fact that recessions (and other events) inevitably happen periodically. Johnson said recessions actually may be beneficial if you’re in your accumulation years. If stock prices fall, systematic contributions to a 401(k) and other retirement accounts can buy more shares each month via dollar-cost averaging. Still, recessions can cause suffering for many, so this isn’t something to root for. The situation could be different if you’re getting ready to retire. In that case, it may make sense to revisit your risk level because significant losses near the beginning of your retirement years can be problematic. If you’ve been dragging your feet on reducing risk, it could make sense to shift some money from stocks to lower-risk investments like bonds if you expect a bumpy economic road ahead.
What You Shouldn’t Do During a Recession
With a solid emergency fund and an all-weather investment portfolio in place, you might not need to make changes if a recession materializes. That’s the beauty of having your finances in order before you experience hard times: You can focus on more important things in life and support loved ones. Still, that’s easier said than done if you’re barely getting by during normal times. So don’t be too hard on yourself if you’re still working on your emergency fund.
Abandon Disciplined Investing
When it comes to your investments, be wary of making emotional decisions if the markets get ugly. If you sell every time there’s a market downturn, you end up buying high and selling low. “Know that market volatility, corrections, and downturns are all normal market behaviors, and they’re nothing to react to. In fact, reacting and trying to fiddle with your investments is exactly where average investors get into trouble,” Roberge said.
Take on Big Expenses
When you risk losing a job or face other economic challenges, it may make sense to keep your expenses as low as possible. Adding significant monthly obligations like a hefty car payment may make things difficult if a recession affects your finances.
