How to Prepare Your Finances for a Recession

A recession refers to a general decline in economic activity. It is a time when unemployment increases, consumer spending lowers, and the economic output is reduced. Interest rates also generally drop as the Federal Reserve tries to support the economy. Typically, if the economy has seen a negative Gross Domestic Product (GDP) for two consecutive quarters, it is assumed to be in recession. The U.S. economy has already been through this in early 2022. However, the National Bureau of Economic Research (NBER) refuted this prognosis and claimed that the U.S. economy was not in a recession in 2022.

Nevertheless, the economy may be headed into a recession in 2023. There have been talks about the Federal Reserve raising interest rates to tackle high inflation. Inflation has been consistently high in the country this year. High-interest rates may help with inflation, but they can also negatively impact the economy by putting it into a recession. Recession can directly affect you in a number of ways. From the lingering fear of losing your job to the falling stock prices and red marks on your investment portfolio, there may be considerable financial upheaval in the near future. However, looking at the recession as a market cycle that will eventually pass is essential. Consider consulting with a professional financial advisor who can advise you on how to prepare your finances for a recession and safeguard your investments.

Meanwhile, you can learn how to recession-proof your portfolio to avoid damages or keep them at a minimum.

How to prepare for a recession

Here are some tips that can help you safeguard yourself from a recession:

1. Bulk up your emergency fund

Your emergency fund may be the first thing you might need in a recession when things begin to go down south. Recession poses the biggest threat to your job. If you lose your job, you can struggle to pay your daily expenses like food, insurance premiums, healthcare bills, retirement contributions, and more. An emergency fund can help you stay afloat. The money from the fund can replace your income until you find a new job and ensure you are able to cover your needs without taking on debt.

Typically, keeping an emergency fund equivalent to at least six to eight months of your monthly income is advised. However, given the circumstances, you may need to save more to make sure you are well-prepared for any adversity that comes your way. You can save up to nine months or more of your income to prepare for emergencies. If you have not evaluated your emergency fund recently, now is the time to check it. Make sure your emergency money is stored somewhere that is easily accessible and would not trigger your tax liabilities or penalties. For example, a 401k account or an Individual Retirement Account (IRA) would not make a good emergency fund, as early withdrawals would trigger your tax liabilities and you would pay a 10% penalty. However, a bank account is a good place as you can access your money immediately. Moreover, you would not pay any tax or fine.  

2. Find a side hustle

Diversifying your income sources will offer you additional financial protection and immunity from the loss of your job. The biggest benefit of a dual income is that you always have a safety net to depend on if you lose your primary job. Further, you have nothing to lose even if you do not face any adversity, such as unemployment. Dual income is always a boon to your financial security. The more you earn, the more you can save and invest. This ultimately contributes to a better lifestyle and more peace of mind. So, start looking for side hustles. When you do so, try to look at different sectors. Some industries may be more impacted than others in a recession. For example, tech companies have already started showing the recession’s repercussions with mass lay-offs. So, if you are working in the tech industry, it may help you look for a side hustle elsewhere.

Additionally, it is also essential to know how to recession-proof your portfolio for a job. This can be done by enhancing your skills. Learn new skills, take online courses, see if you can start a home-based business, etc. Try to remain relevant with the changing times so you can find a job, irrespective of the market cycle.

3. Spend less and cut out discretionary expenses

Factors like your income, the number of income sources, investment returns, etc., may not always be under your direct control, but your expenses can be. Living below your means and lowering your expenses can be one of the most effective ways to prepare for a recession. Recession and inflation greatly influence your purchasing power. And while it may be hard to control some of your expenses like rent, gas, health insurance premiums, etc., you can certainly cut out the non-essential ones. For example, eating at home has been shown to positively affect your budget, rather than eating out. The same can be said for using public transport like buses and subways over using your car or taxi. These little lifestyle changes can go a long way in helping you save more. If things really seem to go out of your control, you can also take drastic measures like downsizing or moving to a relatively more affordable neighborhood.

Cutting out your expenses can be hard. The impulse to buy can be challenging to avoid for most people. However, some strategies can help. For example, using cash over credit or debit cards can be useful. When you have money, you know exactly how much you can spend at a given time. On the other hand, cards or online payment modes can be deceptive as they offer instant payment solutions without any reminder of how much money you have left in the bank.

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4. Postpone major expenses

Major purchases can include buying a house, renovating a home, buying a car, a child’s college fee, etc. If you have been planning for these expenses for some time, it is wise to postpone them until after the recession. Even real estate assets may not be the best investments in a recessionThe responsibility of repaying the home loan or mortgage can be problematic if your employer cuts your salary due to the recession or you get laid off. The same can be said for renovating a home or buying a car. These significant expenses can require a lot of money, so it is better to postpone them and instead use the money for emergencies or as a safety net.

Expenses like a child’s college fund may be impossible to ignore. You are good to go if you have a 529 education savings account. However, if you are using your IRA to fund a child’s education, it may be better to rethink, especially if you are about to retire soon. In this case, you can apply for the Free Application for Federal Student Aid (FAFSA) or let the child opt for a student loan alone that can be paid later once they get a job.

5. Avoid debt

Debt may seem like the easiest source of money, but paying back a loan along with interest can be difficult in an environment like the recession. With no employment security, you would never know when you might lose your job. If this happens, not only would you have your essential expenses, like food, gas, insurance, etc., to deal with, but you would also have to clear your debt. Things can get trickier if you fail to build up an emergency fund. Therefore, be very careful with debt before and during a recession. Typically, interest rates are dropped in a recession to encourage people to take on more debt and stimulate the economy. Lower interest rates may seem enticing. However, interest is still an unwanted extra payment that you pay from your pocket. No matter how low it may be, it is still advised not to add it to your list of expenses unless you have no other option and really require the money.

6. Diversify your portfolio with recession-proof investments

Diversification is as crucial with investments as it is with your income sources. As explained above, a recession may impact some sectors more than others. Therefore, spread your money across different industries and investments. If you are investing in stocks, try including as many shares as possible from different companies and sectors. It is usually advised to keep between 20 to 60 stocks in your stock portfolio, depending on your budget and preference.

It is also important to diversify across asset classes. If you are investing in mutual funds, make sure to include equity funds, index funds, debt funds, etc., to create a balance between equity and debt. Keep your company-sponsored 401k or open an IRA to ensure tax-advantaged savings. This will also help with tax diversification.

7. Do not panic

When the market starts to spiral, many investors panic and sell their investments. This can be your biggest mistake and further impact the market and stock prices. It is recommended to stay calm and adopt the buy-and-hold investment strategy at this time. Let your investments be unless you really need the money for an immediate need. Allow them time to recoup, and meanwhile, continue with your mutual fund installments, retirement contributions, and other investments as before.

What to invest in during a recession

Apart from following the measures mentioned above, knowing where to invest your money in a recession is essential. Here are some options:

1. Bonds

Bonds are low-risk investments that are often used for diversification or right before retirement to lower the risk from a portfolio. However, they can be one of the best investments in a recession. The primary advantage of adding bonds to your portfolio is their stability in an otherwise dynamic market. Stocks can be volatile at a time like a recession and create unpredictability. On the other hand, bonds can be used to balance the risk. Bonds like the U.S. Treasury Bonds do not add any default or credit risk as they are backed by the federal government. Likewise, state and municipal bonds are backed by the state and municipality and are relatively safer.

2. Stocks 

You do not entirely need to remove stocks from your portfolio in a recession. However, it is essential to know the right strategy for stock investing. You must ensure optimal diversification and invest in stocks belonging to companies from different market capitalizations and sectors. For instance, if you are investing in an Artificial Intelligence (AI) company and an automotive company, make sure to also invest in other non-tech sectors like pharmaceuticals, clean energy, consumer goods, shipping and transportation, agrochemicals, etc. Likewise, it is also vital to invest in stocks from different capitalizations – small, mid, and large. However, you may include more large-cap companies during the recession as these companies may be better established to withstand a market downturn.

Dividend stocks can be another option to consider. These stocks share the profits of the company with all shareholders. You get a share of the yield based on the number of stocks you own. You can look for companies that offer dividend stocks and have a suitable track record of consistent dividend payments to recession-proof your portfolio.

3. Dividend-paying Exchange-Traded Funds (ETFs)

Dividend ETFs are among some other recession-proof investmentsETFs expose you to a basket of securities to enhance your returns. Dividend ETFs can be particularly great during a recession as they offer a regular dividend. Moreover, since ETFs can be bought and sold as easily and quickly as stocks, they also ensure high liquidity in case you need urgent funds due to an emergency during the recession. However, make sure to look for companies that pay dividends regularly and consistently before investing your money.

To conclude

Knowing how to recession-proof your portfolio is critical. As per experts, the U.S. economy may see a recession in late 2023 or early 2024. Moreover, some studies also indicate that even if the government is able to control or avoid recession, the adopted policies will increase inflation. Either way, the average investor, buyer, and the taxpayer will be affected in some capacity or the other. Therefore, the measures mentioned above, like saving more, spending less, lowering debt, diversifying your portfolio, and above all, not panicking, are all essential for any situation that might occur in the future.

Additionally, it can also help to hire a professional financial advisor at the earliest to protect your finances and prepare well for the coming year. Use the free advisor match service to get connected with an advisor that can help. Answer a few simple questions on your financial needs and get matched with 1-3 advisors that are best suited to help you meet your financial requirements.

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