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The first step you need to take to prepare for a recession

A recession is generally considered a slowdown of economic activity, as measured by negative GDP (gross domestic product) growth in two consecutive quarters or longer. In Australia, we have been extremely lucky. The last time we saw a (textbook) recession was in 1991! 

Unfortunately, we are likely to have a recession in 2020. The pandemic associated with COVID-19 has sent ripples through economies worldwide. Self-isolation and enforced industry closures are necessary to slow the health crisis, but have all contributed to a slowdown in spending by both businesses and consumers. Temporary lay-offs will also have a big impact on GDP in the near future. 

Hopefully, any recession we have is over as quickly as expected. Regardless, here is one thing that you can do to help prepare.

Build up an emergency fund

An emergency fund is exactly what it says on the tin: some funds set aside for a rainy day. No-one saw COVID-19 coming, and it’s unlikely that we will see the next negative economic event coming. If you are still in the position to, starting an emergency fund is a great idea.

Having a few months’ worth of necessary spending money will help you weather the tough times. It doesn’t matter if the funds are sitting in an offset account on your mortgage, or a high-interest savings account, just so long as they are safe and can be called upon when needed. That means that bonds or term deposits don’t count!

The power of time

An emergency fund is more powerful than you think! If you’re reading this, you’re probably an ASX share investor. Even if you are just holding market-tracking ETFs, your portfolio (like mine) has taken a significant haircut in recent months. As a result, it’s not an ideal time to be selling stocks. 

A great example of this is the Macquarie Group Ltd (ASX: MQG) share price, adjusted for dividends and splits. On 2 March 2009, in the wake of the Great Recession, Macquarie shares sold for $8.98. On 30 September 2009, they sold for $33.93. That’s a 278% return on your investment in 7 months! Now, to put that in context, the Macquarie share price peaked at $44.99 on 10 October 2007. 

But, that’s not the real benefit of your emergency fund allowing you to continue holding your stocks. The Macquarie share price is $84.30 at the time of writing. Someone who had an emergency fund in 2009 and didn’t have to sell their shares is significantly better off than someone who had to sell at the bottom in February and who bought back in 7 months later.

If you sold in February and bought back in September, your return to date is 148%.

If you held from February, your return to date is 838%.

It’s worth mentioning that this is the worst-case scenario for 2009 (and doesn’t factor in the initial purchase price or taxes), but it is indicative and illustrative of the power of being able to hold your stocks for the long term. 

Foolish takeaway

An emergency fund will give you those few months of flexibility and time for both you and the economy to get back on your feet.

Over the next couple of days, I’ll be detailing 2 further steps to help you prepare for a recession.

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Motley Fool contributor Lloyd Prout owns shares in Macquarie Group Limited and expresses his own opinions. The Motley Fool Australia owns shares of and has recommended Macquarie Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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