How To Prepare for a Recession

High inflation and high interest rates make many of us susceptible to the downsides of a recession. If you're already struggling to pay off your credit cards or afford groceries, imagine what would happen if you lost your job.

While no one knows exactly if and when there will be a recession, the economy tends to cycle through boom and bust periods — and you don't want to be caught off guard during a downturn.

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What Is a Recession?

The exact definition of a recession can vary based on who you ask. But in general, it involves an economic downturn — instead of expanding, the economy shrinks.

One common metric for determining a recession is having two consecutive quarters of negative gross domestic product (GDP). 

But not everyone agrees that this marks a recession, as other factors like the health of the job market also come into play.

In the U.S., the National Bureau of Economic Research (NBER) is typically the judge of what is or isn't considered a recession. According to NBER, “A recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” 

So, what does that mean for the average person?

Typically, during a recession, you'll see events like widespread job losses and businesses and individuals struggling to make ends meet. You might find yourself out of work or see a decline in the value of your stocks, real estate, and other assets you own.

READ MORE: What To Do When Your Stocks Are Losing Money

5 Ways To Prepare for a Recession

Because a recession can affect both your income and investments, you ideally want to strengthen your finances ahead of time. 

1. Understand your net worth

Your net worth equals all your assets — like the value of your house, car, investments, and cash — minus your liabilities, like the amount left on your mortgage, car loan, student loan debt, etc. 

But you don't want to just calculate your overall net worth. You want to map it out for a better understanding of your exposures. 

For example, maybe you have a net worth of $100,000, but 90% of that is in stocks. If the stock market crashes by, say, 50% in a recession, that would mean your net worth drops by 45% to $55,000. 

Depending on factors like your risk tolerance and age, that might be more exposure than you're comfortable with. So, you might want to diversify into different asset classes to make your portfolio more stable.

Mapping out your net worth can also help you identify liabilities. For example, maybe most of your liabilities are credit card debt. If you lose your job, you might struggle to keep up with payments. 

But if you mainly had federal student loan debt, a job loss might not be as threatening, since you could be eligible to defer payments.

2. Save aggressively

You don't have to deprive yourself, but if you're honest about your purchases, you'll probably find that sometimes you're spending money because you're bored or trying to impress someone, rather than doing what brings you joy.

Saving aggressively is something that you arguably should be doing anyway. You want to enjoy a life of abundance later on, rather than getting stuck in a paycheck-to-paycheck cycle. And during a recession, you'll be especially thankful that you saved.

Plus, cash is king during a recession. If you save aggressively now, you can have more flexibility to put your cash to work when the economy takes a turn, such as by buying stocks or real estate at reduced prices. 

Put the money into a high-yield savings account (HYSA) or, better yet, a certificate of deposit (CD) while interest rates are still high. 

The reason why CDs are such a good option is because the rate you’re given when you open the CD is locked in for the entire term. So, even if a recession hits and interest rates drop, you’ll still be earning a strong return.

HYSAs, on the other hand, have rates that can fluctuate with the market.

READ MORE: How Much Should You Save a Month?

3. Build an emergency fund

If you haven’t already, it’s time to build an emergency fund. This can help you handle a loss of income or other emergencies during a recession.

Many experts recommend building an emergency fund equal to three to six months' worth of your living expenses, but I think six to nine months is a better goal if you want to err on the side of caution. 

Looking at data from the Great Recession, those who lost their jobs became unemployed for about eight months on average, so you might want to prepare for that scenario.

While CDs are good for your non-emergency savings, an HYSA like the SoFi Checking and Savings Account is your best bet for an emergency fund, since the money isn’t locked in and you can access it as soon as it’s needed.

READ MORE: How Much Should I Put In My Emergency Fund Per Month?

4. Pay down high-interest debt

The more debt you have during a recession, especially high-interest debt like from credit cards, the more risk you face by being unable to keep up with payments. 

Say you lose your job during a recession or your landlord sells your building and forces you to move. You want financial flexibility for those situations, rather than being weighed down by debt payments. 

However, if you can't pay down debt in advance, you might find that leading up to and during a recession, interest rates drop. So, you might be able to refinance to lower your monthly payments.

5. Equip yourself with understanding

The last step is to learn how financial markets and the economy operate.

Recessions have historically been temporary events followed by even bigger recoveries. Even when the stock market has crashed, it has always recovered to reach new highs.

That's not to say that the next recession will follow the same path, but generally, if you're patient, things will get better even if a recession hits. 

So, tune out misinformation that the sky is falling and instead learn how you can benefit by staying calm and spotting opportunities.

As Warren Buffet noted in a New York Times article during the Great Recession, “Bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

READ MORE: What Is Stagflation? How To Invest in a High-Inflation, Low-Growth Economy

What Not To Do In a Recession

It's also important to know what not to do during a recession. 

Remember: Equipping yourself with knowledge can go a long way toward making the most out of an economic downturn.

1. Don’t panic

If you panic and sell all your investments as prices crash, you could be locking in losses. But if you're patient and wait for a recovery, you can avoid these losses altogether. 

If you're in your 20s or 30s, for example, it doesn't necessarily matter if your 401(k) declines for a few years, because you still have decades to go until retirement. 

So don't panic. If history repeats itself, your portfolio will recover over time.

READ MORE: There’s Never a “Good” Time To Invest — Why You Should Do It Now

2. Don’t avoid investing

By continuing to invest during a recession, such as by contributing to your 401(k) at the same rate, you can benefit from dollar-cost averaging at lower prices. 

Assuming that markets will recover over time (as they have after all previous recessions), means investing during a recession will lead to even bigger gains.

3. Don’t think short-term

Sure, things might be tough for a while, but recessions are typically temporary and followed by bigger economic expansions. 

If you have to cut costs for a bit, you can manage, especially if you remind yourself that, in the long run, you're setting yourself up for success.

FAQs

How much should I have saved for a recession?

The amount of money to save for a recession varies depending on your situation, but it helps to have a solid emergency fund. 

Many experts recommend building an emergency fund of around three to six months' worth of living expenses, but if you want to be more cautious, consider six to nine months.

Where is my money safest during a recession?

The safest place for your money during a recession is somewhat subjective, but you might consider assets that are historically more durable during economic downturns, such as gold. 

Or, you might keep more money in a place like a high-yield savings account, where you can safely store money without much risk of losing value.

TL;DR: How To Be Recession-Proof

A recession is an economic downturn that can damage your finances if you're not careful. 

To prepare, you want to have more savings and understand your financial exposures. You also should equip yourself with a better understanding of what typically happens during and after a recession so that you don't panic. 

If you're patient and maintain financial flexibility by lowering your expenses, you can withstand a recession — and even potentially come out ahead.

To learn more about protecting your money, check out these episodes of the Erika Taught Me podcast:

• Money & Investing Pitfalls to Avoid
• 10 Steps Towards Financial Wholeness
• Investing in the Stock Market Explained: A Guide for Beginners

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