How to Prepare for a Recession
by Rachna Bijlani, CFP®
August 16, 2019
The recent yield curve inversion, the trade war with China, protests in Hong Kong and the political instability in Europe are some of the factors that have contributed to the fear of a global recession. What exactly is a recession? A recession is classified as two consecutive quarters of economic decline. It is characterized by a slowdown in consumer spending, which then leads to increasing unemployment, decreasing inflation and consequently, lower interest rates. This is a phase of overall contraction in the economy. During periods of contraction, corporate earnings decrease forcing companies to make lay-offs which leads to higher unemployment. The stock market declines and the bonds usually get a boost due to decreasing interest rates.
The big question now is “How can this affect you and is there anything that you can do to prepare for it?” To be brutally honest, you could lose your job and your investment portfolio could suffer significant losses, thus affecting your ability to achieve your financial goals. My grandmother would often say, “Hope for the best but be prepared for the worst”, so here’s what you can do to prepare for the worst:
Increase your emergency fund ratio- Most advisors recommend setting aside enough cash or cash equivalents to cover 3-6 months of non-discretionary expenses in case of an emergency such as job loss. My recommendation would be to increase this ratio to 6-12 months if you’re anticipating an economic slowdown. However, this benchmark is highly dependent on your individual situation and your specific age & job market. For instance, single income families, people in specialty jobs or older individuals should set aside more in their emergency fund as compared to the standard recommendation.
Manage your debt- It is definitely a good idea to consolidate your debt at this time. Also, this would be a good time to consider refinancing your home, to take advantage of the declining interest rates. As they say, when life gives you lemons, make lemonade!
Reduce your portfolio’s risk level- Take a close look at your current investment portfolio, be aware of your asset allocation and risk level. It is usually a good strategy to decrease your portfolio’s risk and opt for safer assets near the end of an economic boom and to increase the risk in your investment portfolio when you sense the end of a recession. Be defensive and focus on capital preservation and risk reduction to prepare for a recession. It is usually not advisable to liquidate your entire portfolio and sit on the sidelines until the end of the recession because it is impossible to time the market perfectly and you could be missing out on a lot of potential gain in anticipation of a loss, but reducing the level of risk in your portfolio by combining assets with low correlation to each other and to the overall market can be a good strategy in periods of economic uncertainty.
Reinvest dividends- Considering that you have an adequate emergency fund ratio, setting up an automatic dividend reinvestment plan for your stock holdings helps you take advantage of the reduction in stock prices by buying shares of a stock that you already like at a lower price.
Stay clear of emotions- Emotions and cognitive biases often get in the way of making rational financial decisions. If you can’t do it yourself, work with a portfolio manger who can objectively guide you and help you stay clear of emotions like fear and desperation which can lead to poor judgement and panic selling in times of a recession. Work on a rebalancing plan and recession strategy and stick to it instead of falling prey to herd mentality.
Build your cash reserves for investing- You might hate me for saying this, but bear markets are not necessarily a bad thing. In fact, the most fundamental rule of investing, which is, buy low and sell high can be most efficiently implemented in a bear market. Start building cash reserves in a highly liquid account such as no penalty CDs or a high yield savings account, ready to be deployed in a recession. Do your research beforehand, make a list of equities that you wish to buy and start shopping when they’re on sale! However, make sure that the investment is in lines with your Investment Policy Statement and also conduct thorough research at a fundamental as well as at a technical level before making any purchase.
Review your financial plan- Consult with a CERTIFIED FINANCIAL PLANNER™, if you haven’t done so already and get your financial ducks in a row. Be aware of your income and discretionary and non-discretionary expenses. Review your existing investment accounts and analyze the level of risk in your portfolio; reassess your risk tolerance, if necessary. Having thorough understanding of your existing situation is the first step towards preparing for an adversity.
Working towards your financial goals requires old fashioned values like discipline and patience. There are no “get-rich-quick” schemes that work; make a plan, set your boundaries and stay on the path with focus and determination. There’s a beautiful saying in French, “petit à petit, l’oiseau fait son nid”, which translated in English means “Little by little, the bird builds it’s nest.” Keep building your nest, you will be happy with the warmth and security that it’ll provide. Au revoir…until we meet again!