Hearing the word recession creates a feeling of discomfort for many. After all, recessions come with a lot of negatives. For instance, stock market declines, job losses and more.
But what does it really mean for your personal economy and what can you do to still thrive financially during a recession? Let's get into what it all means and how you can prepare for a recession.
So, what is a recession?
Well, economies are cyclical. That means they go through periods of expansion and growth, as well as periods of decline known as recessions. Or more severely, depressions. For example, You know about the great recession of 2008 triggered mainly as a result of the housing bubble in the United States.
During a recession, there is typically a decline in industrial and trade activity. Some major implications that come with recessions include job losses and unemployment, a drop in real estate values and the decline of investment values. And as a result, this decline can severely impact your personal finances.
This is why it's essential for you to know how to prepare for a recession.
That being said, regardless of whether there's a recession going on or not, life goes on and bills need to be paid. The last thing you need is for a recession to become a personal financial crisis for you.
How to prepare your finances for a recession
Here are 5 key tips to help you prepare your finances in the event of a recession.
1. Bulk up your emergency savings
As you work on recession-proofing your finances, it's very important to have emergency savings in place. In a recession, having an emergency fund can save you a lot of stress. It can also help you avoid becoming financially over-extended or having to leverage debt just to get by.
To start, you want to put aside 3 to 6 months of your basic living expenses in an emergency account in the unfortunate event that you become unemployed.
And since recessions can be pretty unpredictable, aim to boost your emergency savings to 12 months of your basic living expenses. This will give you ample time to find a new job. But remember, jobs can be harder to come by in an economy experiencing a recession.
Keep in mind that your basic living expenses are the essential things you need to survive; food, housing, your core utilities, and transportation.
2. Diversify your investments
Ever heard the saying, don't put all your eggs in one basket? Well, the same line of thinking applies to your investments. It's important to have a well-diversified investment portfolio. That means your investments should not all be tied up in one stock or in one real estate property.
You want to make sure your investments are spread across multiple industries and areas so if one industry or area experiences a decline, it doesn't sink your entire portfolio.
For example, if you are invested in the stock market, you can spread your investments across multiple sectors such as consumer goods, healthcare, technology, etc. Mutual funds and index funds are both great ways to diversify. You can also choose to invest in the stock market (funds and bonds), the real estate market, and in small business.
Whatever you invest in, be sure to do your research, be clear on your investment objectives and understand your risk tolerance. This will create less panic for you if a recession comes along.
A big mistake people make is that they start selling every investment they own when the economy dips. This is a bad idea.
If you have a clear plan for your investments and you're in it for the long term, you are in a good place. Your investment is likely to weather a bad economy and come out on top. Talk to a financial advisor if you are confused or feeling stuck regarding what to do.
3. Pay off debt
The last thing you want to do is worry about having to pay off debt in a bad economy, especially with the increased rates of unemployment.
Paying off your debt will save you a ton of money in interest payments. Plus, you'll also be able to put your extra funds toward bulking up your emergency savings and other financial goals.
It's a good idea to focus on paying off your high-interest debt before you consider ramping up on investing. This is because if you have high-interest debt the cost of your interest payments may far exceed the return on your investment.
For instance, if you have a credit card that has a 19% interest rate, then it makes more sense to pay off that debt as soon as you can, given that average long term rate of return on the stock market is ~8% to 10%. Obviously, your rate of return could be much high but you want to avoid speculating or trying to time the market.
4. Learn how to budget and live within your means
Living within your means is the key to building wealth. It also means you eliminate having to leverage debt in order to live your life—no more using credit cards to pay your bills.
Wondering how to prepare for a recession and live within your means? Learn how to budget and determine what budgeting style works best for you. Your budget will help you track your expenses in comparison to what you earn and will highlight areas you can cut back on.
Your ultimate goal should be to widen the gap between your income and expenses as much as you can. You do this by increasing your income and reducing your expenses. The money you have left over is money you can use toward the things that really matter to you, like your savings and investment goals.
5. Create multiple streams of income
The average millionaire has 7 sources of income, and for good reason. Creating multiple streams of income ensures that you increase how much you have coming in. And it also acts as a buffer in case you lose a source of income.
Is there something you're passionate about doing? Something you do that you get complimented on all the time? Consider turning it into a side hustle to generate some additional income. There are also a variety of recession-proof businesses you can consider.
While you can't predict when a recession will happen, it makes sense to always be prepared. If you are wondering how to prepare for a recession, these tips should get you started. Need more help in getting prepared? Check out our library of free courses.