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Things we can’t predict are hard to visualize. Yet, financial recessions are inevitable. So how to prepare for the next recession and why should we think about it now?
A recession can cause permanent financial damage for people who are living paycheck to paycheck. Millions of Americans have suffered and are still recovering from the Great Recession.
In this article, I go over the steps you can follow to reduce the impacts of a recession on your finances. I also describe how to react and invest during a recession.
What Is The Definition Of A Recession?
A recession happens when the economy of a country stops growing and starts declining. In other words, it’s a fall in Gross Domestic Product (GDP) for a duration of at least two quarters (6 months).
Here are the major reasons that can trigger a recession:
- loss of confidence in the economy
- stock market crash
- high interest rates
- manufacturing orders slow down
- housing crash
The Most Important Steps To Prepare For The Next Recession
Build Your Emergency Fund
An emergency fund is money that you put on the side to make sure you can pay for unexpected expenses. I always recommend my clients to have 6 months worth of monthly expenses in their funds.
We don’t know how long can last a recession and how it can impact our lives. That’s why it’s so important to have money ready to help you go through the recession.
A cash reserve can reduce the stress induced by a potential layoff or other financial losses. It can also help you and your family during hard times.
Pay Off Your Debt
An other important step to prepare for the next recession is to pay off your debt. Debt means you’re paying more money than what an item is worth.
Life will be tough next time we enter a recession. People will have to live frugally so they can pay for their monthly expenses and mortgage. The last thing we want for you is to still have to pay debt.
Make sure to have a plan to pay off your debt when you still have an income.
Other Financial Steps To Get Ahead Of The Next Recession
Review Your Budget
A budget is an important tool to help you keep your finances under control. If you want to prepare for the next recession, you must create a budget.
Even if it seems straight forward, creating a budget is not that easy. You need to go over your expenses for the last couple of months and analyze them.
A few apps can automatically create your budget from your credit cards and bank accounts. But I don’t recommend this strategy. If you want to change your spending habits, you need to do this exercise on your own.
Then, you need to identify which categories or purchases you can cut in case you need it. Feel free to remove anything you don’t need right away.
Review Your Investments
If you already have an investment plan, this step won’t take too long for you. But it’s never too late if you don’t have one!
An investment plan describes the strategy to follow depending on different situations. It also make sure you keep yourself accountable. For example, your risk tolerance, assets allocation, behavior depending on different scenarios.
It’s easy to get carried over when investing. Take the time to review your investments. You should verify that your investments align with your strategy. Don’t forget to include your retirement plan in your analysis.
I also recommend you to think about the worst case scenario. Because you want to be comfortable with your choices when it will happen.
Improve Your Credit Score
During a recession, financial institutions are lending money to the most reliable borrowers.
If your credit score is in great shape when it happens, you will have an edge on everyone else. For example, if you were to buy your first home, buying it during a recession can be a great opportunity.
Also, credit monitoring services can help protect your credit reports. Their goal is to alert you if any fraudulent activity is detected. The last thing you want, during a recession, is for your credit score to take a hit because of identity theft.
If you want to learn more about free or paid credit monitoring services, check out the ConsumersAdvocate’s in-depth guide. They compared all major players to identify the best providers.
Start A Side Hustle
A lot of people will lose their jobs during the next recession. A great way to not end up with zero income is to start a side hustle.
A side hustle doesn’t have to be fancy. It’s a great opportunity and plan B to give you peace of mind during chaotic times.
You might even turn it into a lucrative business.
How To React During A Recession?
There is not much you can do during a recession expect keep calm. I know it’s easier said than done, but it’s primordial. The last thing you want is to make bad financial decisions because of the situation you are in.
People will lose their jobs, businesses will close, everything will go sideways. And on top of this, we won’t know how long it will last.
Anyway, we need to focus on things we can control. By following the steps above, you won’t have to worry about your finances. It will give you time to see how things escalate and plan accordingly.
Make sure to follow your financial plan during difficult times.
How To Invest During A Recession?
A prerequisite to invest during a recession is to know your risk tolerance. In other words, how much volatility are you willing to stomach.
After answering this question, you can determine which market you can invest in.
I also recommend my clients to invest for the long term especially during a recession. This is because nobody will know how long the volatility last and how low will investments go.
Diversification is key when building your portfolio for the long term. That’s why index funds are a great investing tool.
An index fund tracks the stock performance of a financial market index. For example, the “S&P 500” tracks 500 large companies listed on stock exchanges in the United States.
You can invest in many companies without having to pay for each individual stock.
However, it’s not possible to determine when assets will be at the bottom. So what you don’t want is to invest your money all at once and see your investments crash by 20%.
Use the dollar-cost averaging strategy to avoid any bad experience. For example, you can divide the money you want to invest in 12 even units. And then invest 1 unit at a time every 2 weeks. Feel free to change the number of units and weeks so you are comfortable with it.
The best thing to do when everything is going well in your life is to plan for the unexpected. When things start to go sideways, you might not have the time to prepare for it.
You don’t have to follow each step of this “prepare for the next recession” financial guide. But the best prepared you are, the easiest it will be for you to face what will happen.