The natural economic cycle, unfortunately, includes periods of recession. Throughout history, recessions have occurred of various magnitudes and for multiple reasons. Every recession tends to be different, and nearly impossible to predict precisely when they’ll happen. Recessions are tied to economic conditions such as higher unemployment, stagnating wage growth, stock market declines, falling real estate prices, and tightening credit conditions. We can’t shield ourselves entirely from recessions, but we can take steps to mitigate their pain in our financial situations. This is our guide to surviving a recession!
Step 1: Evaluate the Risks of Your Financial Situation
Recessions can accentuate or expose risks of our financial situations very quickly. It’s essential to identify the risks of your financial situation and take steps to prepare for the scenario in which a recession occurs.
A handful of risks that might present themselves as part of an audit or your individual financial situation may include:
- A lack of liquidity. How will you cover your fixed expenses or maintain your lifestyle if you lose your job?
- Concentrated allocation within your investment portfolio. Is your investment portfolio too heavily allocated to particular sectors that tend to perform poorly during recessionary periods?
- Reevaluate the timing of large purchases or financial goals. Recessions tend to accompany a drop in real estate values and tighter lending conditions, and it may make sense to re-evaluate the timing of a large purchase or financial goal and “weather the storm”.
Step 2: Create A Plan to Mitigate Risks
Risk #1: Lack of Liquidity
Entering a recession without liquidity can be financially disastrous and mentally stressful. The best way to ensure adequate liquidity is to establish an emergency fund that provides anywhere from 3-12 months of expenses set aside in cash. To determine how large an emergency fund you need, complete a thorough spending evaluation of the prior 3-6 months. This exercise will provide your average monthly spending, which you can use to determine how many months of expenses you should set aside in your emergency fund. Next, you’ll want to consider your income and dependents. Are you the sole income in your household? Do you have people that depend on your income outside of yourself? Do you have upcoming significant expenses or goals you’re saving for in the short term (1-2 years)? If so, consider an emergency fund on the larger spectrum, anywhere from 6-12 months’ monthly expenses. If not, consider the smaller end, between 3-6 months.
Lastly, the key to any solid emergency fund is to keep it in cash or cash equivalents (money market funds or a mix of short-term certificates of deposit or treasuries). If you invest your emergency fund, it defeats the whole purpose of having a stable, immediately accessible account for emergency use.
Tip: If you need to determine your average monthly expenses, try our financial planning software for free! Link all your accounts (credit cards, checking/savings accounts, etc.) to the portal and review the prior 3 months’ expenses to ensure accuracy. The software will produce an average spending figure and also allow you to create a forward-looking budget.
Risk #2 Concentrated Allocations in Investment Portfolio
During periods of economic growth, investment returns can be “easy” to come by. That’s certainly not the case during recessionary periods. It’s natural for investors to build investment portfolios that correlate with their line of work, forgetting to rebalance or having no “rules-based” approach to investing. These pitfalls can lead to over-allocation to individual stocks, sectors, or specific traits in the portfolio. Eventually, when a recession occurs, it can have an outsized negative effect on highly concentrated portfolios relative to a more broadly diversified portfolio.
Evaluate your total investment portfolio to identify concentration risks. For example, are you compensated in company stock, and have you allowed it to accumulate over the years without selling and diversifying? Have you selected individual stocks that all reside within the same sector of the economy? Do you own investments that are located geographically in a single country?
These strategies may have performed well during periods of economic growth or when you just so happened to own the investments. However, over the long term, you’re much more likely to have investment success by maintaining a rules-based approach and developing a broadly diversified asset allocation, rather than having to consistently position the portfolio in “winning” areas of the market. For example 2022, after years of the high-flying technology sector and growth stocks outperforming the broader market, they came crashing back to Earth and value oriented stocks outperformed. Investors who instead maintained a balance approach to both growth and value didn’t experience the dramatic volatility that a pure growth allocation entailed. When the downside pressure occurs, many investors can’t stomach the loss and mistakes are made. Another example, throughout the 2000s, international stocks fared better than their US counterparts. From 2000-2009, the S&P 500 provided an annualized rate of return of -0.9%, often referred to as the “lost decade”. Yet, a broadly diversified investor would have participated in growth by not being geographically isolated with their investments during this period since international companies outperformed relative to the S&P 500.
These are all potential forms of concentration risk that can be easily mitigated by doing a portfolio review and creating an asset allocation that’s more broadly diversified and “rules-based” to reference for future rebalancing.
Risk #3 Reevaluate the Timing of Large Purchases or Financial Goals
While we can’t control the timing of recessions nor predict precisely when they’ll occur, we can control the timing of our large purchases or financial goals. Recessions can have a variety of effects on people’s financial goals. An obvious one may be retirement. It becomes harder for someone to retire during a recession than it does during economic growth. With careful planning it’s not impossible, but it’s definitely not favorable. One of the most significant risks when retiring is “sequence of withdrawal”. Sequence of withdrawal risk alludes to the volatility that a portfolio may experience when the investor begins to withdraw from the portfolio to support their lifestyle. For example, if in the first year of retirement, the portfolio loses 20%, it has a much shorter “lifespan” than if it had gained 20% when considering how long it can support the investor’s retirement. Of course, this can be mitigated by a more conservative asset allocation leading up to retirement, even if a recession occurs.
Likewise, for a younger person considering a career change. A recession will likely put a hold on that goal or should at least make the person reconsider leaving a “comfortable” job. Jobs aren’t necessarily easy to come by during recessions, and if you have safety at an existing job, despite knowing it may not be your long-term employment, waiting until companies begin hiring more consistently is something to consider in the timing of your new employment.
Another significant goal that may be worth reconsidering is a home purchase. During recessionary periods it’s common for lending conditions to become tighter. Unless you’ve carefully planned the home purchase, qualifying for a loan or a loan with favorable terms may be more challenging. However, with careful planning, you may be in a better position to purchase than many other potential home buyers. If the recession has pulled down real estate prices, the tighter lending conditions could play into your favor and weed out other potential buyers. Less competition means buyers could have more leverage in the home purchasing process. Nonetheless, the timing of your purchase and the economic conditions accompanying a recession makes it worthwhile to reconsider and ensure you’re still comfortable moving forward with a home purchase.
The Bottom Line
Recessions are an inevitable part of the economic cycle. Developing a comprehensive financial plan to evaluate ALL the risks is the best way to survive a recession. Financial planning is a dynamic process that helps people maintain peace of mind regardless of economic conditions. There is much we cannot control concerning the overall economy and market. Still, we can be prepared for the worst through deliberate planning, with the ultimate goal of helping people live their best lives by aligning their money decisions with what they value. If you want help to survive a recession and developing a long-term financial plan, schedule a free consultation today!