This is a difficult topic to take on in the current economy. At least right now, a recession seems unlikely, and some are saying impossible. But the current economic expansion – anemic that it is – is now about 10 years old. That makes it the longest expansion on record. As the saying goes, what goes up, must come down, and so it will be with this expansion. That’s why we need to discuss now how to prepare your finances for the next recession. It’s coming.
Preparation is so important, precisely because most people don’t see – or don’t want to see – trouble on the horizon. But if you’re prepared, you’ll be able to minimize any negative fallout.
What can you do to prepare your finances for the next recession?
Prepare Your Finances for the Next Recession – Get Liquid
Liquidity might be the most underrated concept in the personal-finance universe. Some people have six-figure incomes, six-figure investment portfolios, six-figure retirement plans, and six figures in home equity. But when it comes to liquid savings sitting in a bank account, it’s mostly moths and cobwebs.
But when a recession hits, and income, investments, and property values get shaky, the importance of liquidity suddenly becomes obvious. It should be at all times, but when everything seems to be growing in value, and credit can be had only everywhere, liquidity just doesn’t seem as important.
What’s often forgotten is the basic purpose of liquidity is to create a barrier between your immediate financial needs and your long-term assets. With no savings, you’ll be forced to liquidate investments to cover short-term financial needs. And rest assured, forced investment liquidation usually comes at the worst of times. It won’t happen when a particular stock you own has topped out at $100. No, instead it’ll happen after that same stock has fallen to $50. Once you sell it, you’ll have locked in your loss.
Another blogger once said something to the effect that “a lack of money is what causes small problems to turn in the big ones”. That’s the strongest argument for liquidity. An $800 car repair is only a problem if you don’t have cash to cover it. Then you’ll have to turn to credit, or engage in a mad scramble to find it anywhere you can.
Recessions have a way of creating unstable financial situations. You have an opportunity now to insulate yourself against most of them by building up true liquid savings. For most people, having enough in a bank account to cover living expenses for between three months and six months will cover most short-term needs.
Rearrange Your Investments to Prepare Your Finances for the Next Recession
The prevailing investment psychology today is to invest in index funds and ride the market up. After all, based on the S&P 500, the average annual rate of return on stocks has been about 10% going all the way back to 1926. Who would bet against that kind of track record?
The strategy has worked brilliantly over the past 10 years. But this is when it’s important to realize that the oft-cited 10% return is nothing more than an average. Over that 93-year time span there have been years, and even entire decades, when the market has returned something less. During certain time frames, it’s been down – a lot.
Recessions aren’t a time to bet on averages, because they usher in counter-cycles. The investment strategy that works so well during economic expansions may be a guaranteed loser in a prolonged recession.
You don’t need to liquidate all your stock holdings. But you should begin making gradual shifts, such as the following:
- Stop or reduce new stock purchases. Instead load up on cash and fixed income investments. Not only will they protect more of your money from a downturn, but they’ll provide you with the funds you’ll need to begin buying at the bottom of the market.
- Look for more specific investments. Move money from index investing into “dividend aristocrats”, value stocks, and certain industry sectors likely to outperform the general market in a downturn.
- Move a small amount of money into precious metals, cryptocurrencies, and certain real estate investment trusts (REITs) that have performed very well in the last recession and since.
The idea is to move beyond basic index investing, in preparation for a very different kind of investment environment.
Lower Your Debt Level
Debt – which is so easily tolerated during expanding economies – can be a veritable Achilles’ heel during a downturn. That was certainly the case during the Financial Meltdown that began in 2007. It wasn’t so much people who had little debt that got hurt. But those with large debts got clobbered. This was most obvious with housing. People who had either made minimum down payments to buy properties at or near the top of the market, or borrowed all the equity out of their houses, were the most likely to end up in foreclosure.
Culturally, our society makes light of debt. Businesses and economists promote it as a way of generating sales and “stimulating the economy”. But on an individual basis, we should know better. In its most basic form, debt is all about paying yesterday’s expenses today, or today’s expenses tomorrow. It’s a financial imbalance, since it reduces future income. And if a recession causes future income to be uncertain, there may not be enough available to service the debts that are being run up now.
There may not be much you can do about large loans, like the mortgage on your house or large student loan debts. But you should do your best to pay down any debts you can.
The Credit Card Complication
This should certainly start with credit cards. They come with high interest rates, that makes paying them off close to impossible. There’s even a saying to describe that conundrum: Once a Visa, always a Visa. That’s not just someone being cute either. The whole concept of revolving credit is designed to get you into debt, and keep you there forever.
When banks can charge as much is 25% on a credit card, they have every incentive to make sure that happens. Your goal should be to do the exact opposite. Credit cards are the epitome of “bad credit”, and will represent a drain on future income.
But there’s another potential dilemma most don’t consider, and it’s the possibility of credit lines being frozen or reduced in a recession. It happened in the last one, and left a lot of people stuck. The bank cuts your credit line from $10,000 to $5,000; if you owe $4,800 on the card, you’re instantaneously “maxed-out”.
The Car Loan Complication
Car loans are a close second to credit cards, but in a different direction. The basic problem with a car loan is the large monthly payment. With today’s car prices, it’s not unusual for a monthly payment to be $400, $500 or more. We may have gotten used to that in recent years, but it will be difficult to manage on a reduced or eliminated income.
Complicating the car loan situation is the fact that financing represents a lien against a survival asset. A car is a survival asset because it’s required to make a living for most people. At a minimum, that involves the ability to commute to and from a job. But if you have a business, it can be even more important. In either situation, should you lose your car to repossession due to inability the service the debt, not only would your credit be crushed, but your ability to earn a living would be impaired.
If you only owe a few thousand dollars on your car, pay it off as soon as possible. And if you owe a large amount, pay down as much as you can. The idea is to get it low enough that you may be able to pay it off if you lose your job or are forced to take a major pay cut.
The Best Way to Prepare Your Finances for the Next Recession – Have a Back Up Income Source
One of the most common features about any recession is the elimination of jobs. But in the more complex employment world we’re in now, underemployment could be the bigger problem. People working full-time could find their hours cut to part-time, as employers look to cut costs.
Are you even remotely prepared for that type of outcome? You need to be. Most make the general assumption that they’ll be able to weather out any short-term income disruptions by a combination of savings and unemployment benefits. But each has limitations.
Unemployment benefits are only a fraction of your employment income. And since they cap benefits at a certain flat weekly amount, the situation is even more pronounced for higher income earners. For example, in Georgia, the maximum unemployment benefit is $330 per week. But if you currently earn $1,000 per week, that will only replace one third of your income.
Still another issue on the unemployment front is that it’s now easier for employers to block your benefits claim than ever before. They have an incentive to do this, because the higher the number of people they have collecting benefits, the higher their contribution rates into the fund will be. It’s entirely possible your unemployment claim will be denied.
You may be able to rely on savings, and you absolutely should have them prepared. But that will only work as a short-term solution. If you’re either unemployed or underemployed for a year or longer, you can completely drain your savings.
A Side Business to the Rescue
That’s why a backup income source is important. It can provide an income if you’re denied unemployment benefits, as well as minimize the draw down on your savings. And if your hours are reduced in a crunch, the second income source can fill in the gap.
I often recommend starting a side business on this website. But it can become downright critical to prepare you your finances for the next recession. Not only can it be a source of income during the time of unemployment or underemployment, but the second income can provide additional funds to build up savings and pay down debt.
Starting a side business is worth doing even if you’ve never contemplated it before.
Many people, fearful of the entire prospect of self-employment, reason they can achieve the same outcome with a second job. That idea is loaded with pitfalls, especially in a recession.
First, a second job could be lost just as easily as a first job – and even for the same reasons. Second, since second jobs pay on an hourly basis (and not very much at that) your income potential will be limited by the number of hours you can work. Working too many hours can lead to burnout, which will put an end to juggling two jobs.
Finally, there’s the fact that competition for part-time jobs tends to become heavy during economic downturns. The second job you assume to be there may not when the storm arrives.
Carefully Evaluate Major Spending Plans
If you’re preparing to buy a home, or to trade up to a higher-priced home, or by a second home or a brand-new car, this may be a good time for some serious reflection.
Historically, people tend to buy houses and cars at or near the top of an economic cycle. After several years of steady economic growth and stable income, they reason that it’s safe to make a major purchase. Unfortunately, that kind of thinking can lead to personal financial disaster.
The saying on Wall Street is “buy low, sell high”. But when you buy at the top of an economic cycle, you’re doing the exact opposite. Chances are, any house or car you purchase will be more expensive now than it will be when the economy sinks.
This is another major reason so many people ended up being “underwater” on their mortgages in the last recession. They flocked to buy overpriced houses at the top of the previous market, often with zero down payment loans, and ended up in a negative equity situation.
Be careful of adding any major obligations to your current budget. You’ll be forced to maintain those obligations at a time when circumstances may not be so favorable.
A wiser use of additional funds may be to increase savings and either reduce or pay off existing debt.
It all figures significantly in how to prepare you finances for the next recession. You should do that now while you have the time.