How to prepare for a recession

Photo by Copta from FreeImages

In today’s post, I am looking at what are the causes of and how to prepare for a recession.

Our economy is cyclical, we have had times of great economic prosperity for the past 10 years.

Eventually, we will have a contraction, where we see unemployment rates go up, consumer confidence fall and possibly leading to a decline in GDP.

When the above-mentioned things happen, we will see a recession at some point in the future. So the question is not an if but a when.

If you’ve been reading the news, then you’ve seen the headlines, the next recession is predicted in 2020 by big-name publishers like the New York Times.

One of the reasons for all these publications is this: fear sells. They’re just trying to get you to read their content.

At the same time, other articles will report that a recession might not happen yet.

Why is this? Because predicting the next recession is incredibly difficult.

What causes recession

Too much optimism

People get overconfident in the market, they get overconfident in business, in their ability to invest. You might have heard about how some real estate investor is a multi-millionaire because of how brilliant they are.

What if they are over-leveraged? They borrow too much and as soon as the economy tanks, then all a sudden, their situation might turn for the worst.

The economy is interdependent on each other, so when one thing is out of whack, for example, the housing collapses 10 years ago, this can wreak havoc to the economy and tip the scale.

Excessive credit

When the economy is doing great, people have enough confidence to borrow money, sometimes excessively.

Consumers will feel like they can open up new credit cards, borrow loans and keep a balance without worry.

Especially when the unemployment rate is low. The US unemployment rate is 3.8 percent as of March 2019.

However, when the economy is spiraling down, and people start to lose their jobs. What happens to all the bills that have to be paid off?

According to Magnify Money, the revolving credit card balances in the US as of January 2019 are $1.03 trillion dollars.

And according to Forbes, the total student loan debt in 2019 is $1.5 trillion dollars.

These two American debts can and will push us toward the next recession in the near future.

The Inverted Yield Curve

According to the Washing Post, the yield curve has inverted before every U.S. recession since 1955.

recession indicator
Source: Washington Post

When investors start to get spooked about the future of the economy. Such as a potential slowdown or a recession in the future, an inverted yield curve will occur.

When things get rocky, investors will pour money into the 10-year bond because these bonds are viewed as a safe investment.

The rule of supply and demand will drive up the prices of these 1o-yeard treasury bonds, thus decreasing yields. Eventually, the yield will go below that of short term bonds.

Short term treasury usually taking 2 years for maturation, an example is the U.S. Treasury 2-year bonds.

The yield curve occurs when the interest rates have flipped with the short-term bonds (2 years) paying more than long-term bonds (10 years).

Interest Rates

One of the tools in the arsenal of central banks, i.e. The Fed in the U.S. to prevent a recession is to change interest rates.

The Fed can cut interest rates to stimulate economic growth. Lower rates encourage borrowing and investing. However, when interest rates are too low, this can lead to excessive borrowing and investing. Too much growth can cause inflation to rise.

On the other hand, when the Fed wants to reign in on excessive economic growth, they can increase interest rates. The increased rates will slow down growth and decrease inflation.

You can get a more detailed explanation from Investopedia here.

How to prepare for a recession

I will break down moves you can do to prepare for a recession into two categories.

  • Defensive
  • Offensive

Defensive moves

Pay off high-interest debts or all debts

This way you don’t have to worry about them when the market tanks. During a recession, you may possibly lose your job depends on the industry that you work in of course.

Establish 3 to 6 months of an emergency fund

Dave Ramsey recommended saving at least 3 to 6 months of expenses for emergency funds. However, some financial experts are advocating for 12 months of expenses.

So if you’re able to save money to cover at least 3 to 12 months of living expenses.

Do not panic sell

This goes back to the concept of buying high and selling low. John Bogle and Taylor Larimore both recommend for you to stay the course and leave emotion out of investing.

It’s especially true during this time when the market has wild fluctuations. Remember that your long term strategy is to buy and hold.

The market will go through corrections at times, a phenomenon known as reversion to the mean.

When you sell low, the loss is permanent, if you weathered the storm, you’ll regain back losses and possibly grow your investment.

In fact, this is a good time to buy instead of sell.

Offensive moves

Build-up your investing fund

Save up as much money as possible to grow your war-chest to buy assets during a recession.

Let’s use real estate since I talk about investing in the market too much. Let’s go back to the 2007 and 2008 market crash.

If you had the money to buy properties during the time, your properties right now would have doubled or tripled in value.

Buy low and sell high

The recession doesn’t happen overnight, even with indicators like the inverted yield curve, a recession might occur many months later.

This is a good time to build up your “war chest,” which is money saved outside of an emergency fund or rainy day fund.

Save your money and wait until the recession is in full swing. This is the perfect time to go in and scoop up index funds for a bargain.

If you look back on history, during 2007, the 2008 market crash. If someone invested their money during that time, their money would have grown significantly from 2008 until now.

Of note, you have to take into consideration your current age and time horizon until your retirement when making these decisions.

Also, stocks are not the only opportunity present to you during this time. During a recession, you can definitely find real estate deals at rock bottom prices.

Dollar-cost averaging

Another offensive move you can make is to buy a fixed amount into the market at set intervals.

It doesn’t matter if you do it weekly, bi-weekly, monthly or quarterly. Set yourself up to automatically buy index funds shares during these intervals.

The idea is that when you do this and the market picks up, your buying price baseline is averaging lower than the future market prices.

Basically, your average prices will be lower than if you were to buy funds as a lump sum.

This strategy is best suited for securities such as ETFs and index funds. However, with index funds, you needed to meet their minimum investment amount.

This amount is usually $3,000 with Vanguard, you may need to bump up your investment up to $10,000 to avoid additional fees.

Update your resume and CV

Lastly, since there’s a chance that you might be laid off during the recession, it’s time to update your resume or cv just in case.

Final thoughts on how to prepare for a recession

I am not predicting a recession to occur in 2020, but I do believe in the cyclical nature of the market.

I also believe in reversion to the mean, market forces will tend to correct itself over time.

The best way to prepare for a recession to accept that it’s bound to happen and create an appropriate plan.

How to prepare for a recession recap:

  • Pay off high-interest debts or all debts if possible
  • Build an emergency fund for 3 to 12 months
  • Don’t panic sell
  • Build a war chest
  • Adhere to the buy low, sell high strategy
  • Utilize dollar-cost averaging
  • Update resume and C.V.

One final point of caution is to not use historical returns as a tool for future projections.

You’re taking a risk when you’re buying into the market in a recession.

The chances that the market picks up again is good due to its cyclical nature but it is not guaranteed.

Once again, the best strategy is to buy and hold. Rebalance as needed and invest long term and don’t look for short-term gains. Ignore the noise and do not try to time the market.