How should you prepare for a recession?

Good morning! How are you enjoying the spring weather these days?

Good morning my friend! I love spring weather. It brings back leaves to the trees and there are colorful flowers all around. It just feels like things are back to life after a cold and dreadful winter.

I totally get what you are saying. The transition from zero greenery to trees coming back to life is amazing to see. It affects my mood in a good way and I start to feel more optimistic about life. However, it is hard for me to feel optimistic about the economy these days where everyone is talking about an upcoming recession.

Yes, recession seems to be the talk of the town these days where everyone is coming up with the probability of a recession. I saw that probability going up by 10% on any bad news and coming down by the same amount for any good news in the economy. Overall, I don’t think anybody has a clue when recession is going to happen and how bad it will be.

I also get the same feeling because the same people who seem very confident about their predictions on a given day, change their predictions the very next day. It seems pointless to follow their analysis with any conviction or make any plans. However, this got me thinking that I do not have a plan to tackle a recession or even prepare for one. Can you help me with that today?

Yes, of course! It is always better to be prepared with a plan and know what to do in a recession. As you can already tell, recession can cause a lot of emotional turmoil and it is easy to make the wrong decisions if you are not thinking straight. A plan would definitely help you to keep the emotions out of your decisions. In the best case scenario you may not even have to use it but it is good to have it in your bac pocket for the future.

Let us quickly recap what a recession is and why they occur because it has been a while since we talked on this topic. [Check out this blog to learn about what recessions are and why they happen] A recession is technically defined as two consecutive quarters of negative GPD growth. The main cause of a recession is a slowdown of spending in the economy and since spending is a measure of GDP growth, it results in a slowdown of GDP growth. Like we talked last time, recession is part and parcel of an economy’s life cycle. There is an expansion phase in the economy where people borrow money to increase their spending and GDP grows at a fast pace. This expansion phase is followed by a contraction phase, also called recession, where the borrowed money has to be repaid and this reduces the ability of people to spend. The degree of expansion and contraction is influenced by a variety of factors in the economy like craze of a new technology, printing of money by the Federal government to deal with a pandemic or poor judgement in lending money by big corporations to satisfy their greed. All these events have actually happened in the US economy, which resulted in noteworthy recessions, so much so that they were given special names .

To cut the long story short, recession should not come as a surprise, in fact you should expect to see recession phases in the economy several times in your lifetime. If you look at US history, there has been a recession every decade since the 1930s. Even though there have been so many recessions, the stock market overall has gone up if we look at an index like the S&P 500 that tracks the 500 largest companies in the US. This means that if you stay invested in the economy, there is a high probability that you will make money in the long run. The overall growth of S&P500 also suggests that the degree of contraction during a recession is always smaller than the subsequent increase during the expansion phase, hence the net positive returns over the long term.

That was a great recap! I remember our conversation on why recessions occur and since then I have started viewing the economy in terms of expansion and contraction phases. I am shocked to know how consistently recessions have occurred in the past i.e. every 8-10 years. I have heard of a few of those mentioned multiple times like the Great Depression of the 1930s, the Dot Com Bubble of the 1990s and the more recent Financial Crisis in the 2000s. I would be interested to know more about these but will save it for a later discussion. The most reassuring thing I heard you say was that the growth of the stock market in the expansion phase is much higher than the contraction or recession phase. This makes me somewhat relieved to know that the good times are much better than the bad times. How do I make sure that I do well or at least not do worse.

That is a very relevant concern. They say that more millionaires are created during a recession that any other time. So, you could also make the most out of a recession but I understand the need to keep your head above water. Let us walk through some steps you can take to protect yourself and your family:

1. Bolster your emergency fund: We had talked about the financial order of operations, remember where we discussed how you should proceed with using your paycheck. [Check out this blog to find out what you should do with your paycheck to start building long lasting wealth] Very early in this order is the step to build an emergency fund. This fund is meant to take care of your living expenses for at least 3-6 months in case you lose your job. Since recession comes with massive layoffs across all businesses, it is very likely that you could also lose your job. It is therefore important that you have an emergency fund in place and if possible you need to build it further when recession fears start surfacing. You have to remember that during recession businesses look to cut spending and that is why they let go off people to reduce their overheads. Therefore, if you lose your job during these times it is hard to find a new one quickly, so it is recommended to increase your emergency fund to cover 9-12 months of your living expenses. This would ensure less stress for you and your family while things get back to normal.
2. Spend only on essentials: In order to save more money for your emergency fund, you would have to cut back on your spending. Regardless of the situation, you should never spend beyond your means but during these times it is more than just a guide but a must. Look at your monthly spending and cut down on things that you can avoid, maybe you eat out less, get rid of some your subscriptions, pause your memberships that are not absolutely necessary, etc. These decisions might cause some discomfort but you would thank yourself later. It goes without saying that you should not take on high interest debt like credit card debt during these times. Delay any discretionary spending and if possible pay down any existing high interest debt first. Besides putting the extra money you save towards the emergency fund, you can also invest that money and ensure high returns in the future. More on that later.
3. Invest your money: Usually when recession fears are high people start selling assets because they think that the economy is collapsing and they might lose everything. This happens because humans are emotional creatures and fear is a very strong emotion that makes them act irrationally. When the majority people are looking to sell their assets and not a lot of people are willing to buy, then automatically prices of assets take a nosedive. You can easily see it in the stock market these days where there is a massive sell off, worth trillions of dollars, every couple of days. You should respond to this drop in prices of assets just like you respond to a sale on a Black Friday. You look to buy what you are interested in at a discounted price. The most important thing here is to know beforehand what you are interested in, which could be a particular stock or index fund or real estate. If you have done your homework and know exactly what you want to invest in then you can track its price during these times and as soon as you sense it has gone down enough where it makes sense for you to buy, put your money to work. The best advice I can give you related to investing in index funds like VTI, VOO, VGT, etc. is that you should use the dollar cost averaging strategy. This means investing small amounts of money over regular intervals as opposed to investing a lump sum amount at a single instant. The reason this strategy is better is because you never know when the index funds have reached their bottom, so if you keep investing small amounts at regular intervals there is no pressure of figuring out when the market has bottomed for you to make a lump sum investment. If you are already dollar cost averaging your investments then either continue it or increase the amount/frequency of investments since you would be able to buy more shares at less of a price. 

Those are three steps that I can definitely remember and they make a lot of sense. I am already starting to spend less and save more but did not realize that I could be increasing the amount of investments. I never thought of the recession as a sale of assets. There is so much fear around that you tend not to look at this situation from a practical point of view. There is a lot of pain and uncertainty around but if you have enough savings on hand then you can put it to good use. My first objective will be to build an emergency fund for 9-12 months and then from then on invest any excess cash I have. This has been an extremely fruitful discussion for me and like always I feel far more comfortable than when I started talking.