According to Google, roughly 150 news articles came out over the last week about recession concerns. So if you are feeling anxious about your financial future, it’s understandable. Although most people do not need to worry, we do anyway, and the barrage of media coverage surely doesn’t help. And maybe, in this case, that’s ok because even if you are unlikely to be affected, it is a good idea to educate yourself about what is actually happening (vs. what the media says) and learn how to prepare for a recession.
In my role as a holistic financial planner, I get a lot of questions about this topic from my clients. So in the following post, I will share what I tell them about what is occurring, where the threats and opportunities lie, and steps they can take to protect themselves.
What is a Recession?
A recession is simply an extended period of time during which the economy contracts. Common signs that we might be entering a recession include (but are not limited to) the following.
- At least two-quarters of gross domestic product (GDP) decline.
- Increased unemployment and hiring freezes.
- Stagnant income growth and income reductions.
- A slump in consumer and business spending.
- Periods of high inflation (which can trigger recessions) or rapid deflation (indicating that a recession is already underway).
- Falling stock prices.
However, no one really knows whether we are in a recession.
We see the signs, but they could be byproducts of other activities. For example, during periods of rapid inflation, the U.S. Federal Reserve often raises interest rates to slow down price increases. That, in turn, can cause market volatility and reduced spending, but it doesn’t necessarily cause a recession.
In addition to adjusting interest rates, there are other things our government might do to avoid a recession. For example, they might increase or reduce the amount of money in circulation or make changes to tax policy. Again, these are normal and necessary responses to outsized economic shifts, but it does not mean we are in a recession.
We only know for sure that a recession has occurred after the fact.
It might be comforting to know that a recession’s effects are often overblown. For example, unemployment doubled to 10% during the Great Recession of 2007-09. It was uncomfortable, but roughly 90% of the workforce was still employed.
Still, recessions often feel worse than the story told afterward by statistics. More importantly, if you were among those who lost their job, the fact that many others were still employed likely did not make you feel any better.
How Long Do Recessions Last?
Recession duration can vary widely, with records showing them lasting anywhere from ~two months to ~five years. There have also been economic changes over time, making attempts to pinpoint an average duration or severity elusive. That said, you can expect a recession to last, on average, between 12 and 18 months.
But, quite frankly, it doesn’t matter what the pundits say. What matters is your experience.
Anyone who has been unemployed can tell you that unemployment rates can be infuriating because we stop counting people after a certain amount of time passes. So if you get frustrated and stop looking for work or settle for a job that pays less than you need, you are no longer included in those statistics, even though you are worse off than before.
Therefore, if you sail through a recession relatively unscathed, you will barely notice it. But, if you are unfortunate enough to lose your job or run a business that fails during a downturn, the effects are incredibly personal. Your experience may be more akin to a depression (a severe, long-term recession) in that you may find yourself scrambling to recover for years, even after economic growth returns. That is why learning how to prepare for a recession is essential.
What Threats and Opportunities Occur During a Recession?
Anytime there is a change in the status quo, new threats and opportunities arise. So let’s take a good look at what can happen during a recession so that you can prepare for the worst and take advantage of any possible upsides.
Potential Threats of a Recession
Reduced Spending Power
High inflation can trigger a recession. When prices go up, we get uncomfortable and hesitant to spend money for fear that we won’t be able to afford what we want and need. Unfortunately, inflation is also rough on businesses. When costs go up and demand goes down, they either need to accept a profit reduction or find ways to reduce costs. That often leads to job cuts and can become a vicious cycle.
Unemployment and Fewer Job Opportunities
During an economic downturn, businesses must make tough choices. So, job losses occur, and companies put hiring plans on hold. That makes the work harder for the remaining employees, and the unemployed can’t find comparable replacement jobs. Of course, if a particular industry or organization falls on rough times, this can happen even when the economy is fine. But when a recession occurs, it happens on a broader scale.
Lost Income and Uncertainty in the Future
When the stock market and business environment decline, people pull out of the market (often at a low point), and businesses reduce spending. That causes additional declines in stock prices, sparking concerns about the future.
Even if you don’t lose your job, that could mean lower bonuses or fewer hours. Suppose you don’t have enough savings or have made unwise investment choices. In that case, this can be devastating, leading to missed opportunities, business failures, unpaid bills, mortgage foreclosures, car repossessions, an inability to pay tuition, etc.
A Physical and Mental Health Decline
Significant stressors like those above can seriously affect your physical and mental well-being, leading to depression, substance abuse, or worse, regardless of your economic status. For instance:
- Young people with limited resources may worry about basic living expenses or keeping up with student loans.
- Couples in their late 30s or early 40s who are finally comfortable in their careers and making good money also have more financial obligations. Being forced to choose between paying your mortgage or pulling your kids out of private school could result in an identity crisis that rocks the foundation of your family.
- Retirees and pre-retirees feel significant stress when the market tanks, putting their nest eggs at risk.
As awful as this might sound, it is not all gloom and doom. There is plenty you can do to protect yourself. You may even find a way to improve your situation, so let’s explore some possibilities.
Potential Opportunities of a Recession
Cost Savings
Although a recession may diminish your spending power, it might inspire you to develop healthier spending habits. For example, you could finally address those unwanted subscription charges on your credit cards or switch to less expensive brands at the grocery store, resulting in significant savings for years to come.
During an economic downturn, certain things also become more affordable. For instance, if home prices come down and you are in a position to buy, it may be a good time to leap. Or, if you already own a home, consider requesting a reassessment of your property taxes or refinancing your mortgage to save hundreds of dollars every month.
Career or Business Reinvention
Although losing your job or facing a major change at work is always scary, some people use the opportunity to invest in their future. It could be as simple as learning new skills so you can pursue different roles or as grand as starting a new business.
If you already own a business, a recession can change the competitive landscape, leaving a gap in the market that you are uniquely qualified to fill. On the other hand, some business models do incredibly well during recessions, giving rise to more opportunities, low-cost business loans, or a stronger position for contract negotiations. The possibilities are endless if you can find a way to put your fears to rest and get creative.
Roth IRA Conversions
If you have been thinking about doing a Roth IRA conversion and are experiencing a down year, this may be the perfect time to make that happen.
When you do a Roth IRA conversion, you must have some extra money to pay the resulting taxes, but the taxes will be much lower if you are in a reduced tax bracket due to a job loss or similar income hit. Therefore, if you feel confident that you will eventually get a new job and have some cash available, take advantage of this opportunity for tax-free investment growth.
I recently wrote an entire article on Roth IRA Conversions for MarketWatch. Check it out if you wish to learn more.
High Interest Rates
If you already did some financial planning, put aside some emergency funds, and are wondering what to do with them, periods of high interest are a great time to shop around. You can find savings accounts that offer a higher yield or buy a certificate of deposit (CD) that provides a much better return than these investment vehicles typically offer when rates are low.
Investment Resurgence
Although your investment portfolio may suffer a loss, please remember these losses are likely temporary. Also, down markets can create wonderful opportunities to buy companies when they are on sale. Investing in the stock market is a long-term game. Remember to refrain from engaging in marketing timing behaviors, and have a diversified portfolio.
How to Prepare for a Recession in 7 Steps
So what recession preparation steps can you take today to protect yourself or to take advantage of opportunities? As with most things, it will depend on your unique situation, so I encourage you to talk to a financial advisor who can examine your personal finances and make relevant recommendations. That said, here are some high-level steps anyone can take.
- Develop or revisit your financial plan and monthly budget.
Make sure everything is up-to-date, you know where your vulnerabilities lie, and you are still on track to meet your long-term financial goals. A good financial plan will be recession-proof. - Stress test your plan.
Think of the worst-case scenario, how you think you would react, and how your reaction might affect your cash flow and retirement planning. Then use what you learn to make adjustments. - Build an emergency fund.
An emergency fund is crucial for everyone, but the right amount can vary. For instance, if you rely on distributions from a retirement account for income, you need to protect that nest egg. In this case, I recommend keeping 24 months’ worth of distributions in emergency savings. Then, if the market tanks, you can stop pulling funds until it recovers. - Manage your debt.
Treat debt as a tool that can help you weather ups and downs. For instance, consider setting up a low-interest line of credit now (while you still qualify) if you think your job is at risk. - Reevaluate spending plans.
If you are vulnerable, consider delaying, prioritizing, or adjusting certain expenditures. - Invest in job security.
Find ways to make yourself more valuable by acquiring new skills, obtaining certifications, or switching to a different position if you believe your role is not secure. - Carefully consider the opportunities above.
Although this is just a sampling, getting yourself into a stronger position will protect you now and in the future.
How to Prepare for a Recession: The Bottom Line
Economically, it is never the known knowns that get you; it’s the unknowns. So, building a financial plan is vital. In addition to helping you pursue your financial goals, it will guide you through the day-to-day, so you can make the most of the good times and develop strategies for coping with whatever surprises life has in store. If you want to learn more, we encourage you to download our checklist of issues to consider during a recession or market correction for additional insights.
