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How to Prepare for a Recession

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Article last updated: 8 May 2020

Recessions are an economic reality. They’re also difficult to predict with any precision; they typically start before anyone even knows they’re happening and end before economists have enough data to know they’re done. 

Although recessions are usually fairly short, the individual impacts of a recession can be much bigger and longer-lasting, causing permanent financial damage to those who may not have the means or financial security to ride out any short-term implications.

While we haven’t seen a recession in Australia since the June quarter of 1991, we only need to look to the US to see a more recent example of the devastating effects a recession can induce. Millions of Americans still haven’t recovered from the Great Recession in 2008–2009. Unfortunately, many never will. 

So putting it all together, taking steps to protect yourself and your family from the potential consequences of a recession is not only important but necessary. Let’s take a closer look at what a recession is and what you can do – starting today – to make sure you’re as prepared as possible for the next recession.

What is a recession?

A recession is generally considered a slowdown of economic activity, as determined by negative GDP (gross domestic product) growth, lasting 2 consecutive quarters or longer. The US National Bureau of Economic Research has a more expansive definition of a recession:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.

Looking beyond the dry textbook definition, recessions mean real economic harm. Moreover, the end of a recession is marked by a return to economic growth, not the full recovery of the economy to pre-recession levels. In other words, people affected by a recession often continue to struggle long after economists have said the recession is over. 

According to the Parliament of Australia, there have been 4 recessions in Australia since 1960: 1961, 1974–1975, 1982–1983, and 1990–1991.

Chart: author’s own. Data source: Australian Bureau of Statistics

Australia holds the world record for the longest period without a recession – 28 years and counting since June 1991. Unfortunately, this run appears likely to soon come to an end as COVID-19 takes a toll on our economy.

GDP is measured quarterly for the quarters ending March, June, September and December. The Australian Bureau of Statistics typically releases National Accounts (which contains GDP data) on the first Wednesday of the following quarter. So, we can expect to see the initial effects of COVID-19 on GDP when data for the March quarter is released on 3 June 2020. 

In the meantime, the governor of the Reserve Bank of Australia, Dr Philip Lowe, has commented on the outlook of our economy. According to Dr Lowe, over the first half of 2020, Australia is likely to experience the biggest contraction in national output and income (which form the basis for measuring GDP) since the 1930s. Dr Lowe noted that putting precise numbers on the magnitude of this contraction is difficult, but believes national output is likely to decline by 10% over the first half of 2020, while the unemployment rate is likely to sit at around 10% by June. 

This certainly paints a sobering picture of our economy. So with Australia on the brink of its first recession in nearly 30 years, how financially prepared are you?

The first 2 things to do to prepare for a recession

When it comes to preparing for unexpected financial events, there are 2 things you can do that will have the biggest impact on your ability to ride it out and emerge unscathed on the other side: 

  • Pay off high-interest debt and keep other debt to a minimum
  • Build up an emergency fund

Let’s take a closer look at why these are by far the 2 most important things everyone should do first.

Keep debt to a minimum (and pay off high-interest debt ASAP)

Debt isn’t always such a bad thing. It can actually be a wonderful financial tool when used responsibly. For instance, buying a home without a loan is impossible for most of us. And student loans, like HECS or HELP debt, allow Aussies to gain further education and boost their employment prospects. These types of debt are typically considered ‘good debt’ in that they will ideally help to build wealth and lead to an overall improvement in one’s long-term financial position – used responsibly, of course.

When debt is damaging – especially during a recession, when your financial resources may be more limited – is when it’s expensive and not beneficial. For instance, using credit cards to buy items you don’t have the cash to purchase and not paying them off at the end of the billing period is one of the most financially destructive actions you can take. 

Here’s an example. The average credit card interest rate is around 17%. If you charge $1,000 to the average card and only make the minimum payment (typically 2% of the balance or $20 minimum), a handy credit card calculator tells us you’ll end up spending $1,751 over 7.3 years to pay that $1,000 purchase off.

By paying off high-interest debt and keeping other debt to a minimum, you’ll do yourself and your financial situation 2 big favours:

  • You will spend less money to acquire the things you buy (and buy less stuff you don’t need)
  • You will reduce your monthly expenses, meaning you won’t have to set aside as much money for emergency savings (more on this soon)

If you have multiple debts, you could choose to tackle this in different ways. Naturally, everyone is different, so decide what works best for you. The 2 most common methods are the debt avalanche and the debt snowball. The debt avalanche involves tackling the debt with the highest interest rate first. In this way, you’d be maximising your savings on interest. 

On the other hand, the debt snowball involves crushing the smallest balance of debt first (while still making the minimum payment on higher debts). Since the smallest debt should be the easiest to knock off, paying it off first can help to create a positive feedback loop and motivate you to keep going. 

Once you’ve got your debts under control, another step you may want to take is to reduce your credit limit. This can help you to avoid falling back into the same trap, living beyond your means.

Build up an emergency fund

Now, this is the most obvious step to take, and it’s one that you’ve surely seen in every other financial-preparedness article you’ve read. What may not be so clear to you is how much you should have saved. There isn’t a single answer to this question that fits everyone, but there are some pretty good basic guidelines to follow. 

In general, it’s recommended that you have at least 6 months’ living expenses in savings. This means enough money to cover your housing and utilities, basic necessities like food and personal care, and other financial obligations like loan and insurance payments. So, take the time to work out just how much it would cost you (and your family) to get by in a typical 6-month period.

The next step is to gradually build up your safety net. It may take a year or even longer to save up enough cash to reach the 6-months-in-savings mark. That’s ok; just set the goal and put a plan in place to reach it. This might involve setting up an automatic transfer to direct money straight to your emergency fund when you receive your wage.

Once you get to 6 months, keep saving with a goal of 1 year in savings. That’s particularly true if you own a home or have dependents living with you. The reality is, in those situations, your financial liabilities are higher, and you want to have the resources at hand to deal with the unexpected.

With an emergency fund, you can’t expect much of a return on your savings. But remember, the purpose of emergency savings is to be there in an emergency, not to get sexy returns. Sure, you should stick it in the bank account that will deliver the highest interest. Just don’t go buying ASX dividend shares because you can’t get a 3% interest rate from your bank. Investing your emergency fund ties up your capital and exposes it to the sometimes extreme short-term volatility of the share market – not to mention that it defeats the entire purpose of having an emergency fund in the first place. 

An emergency fund is all about providing you with a financial safety net so you don’t have to borrow money if something unexpected happens to you or your family. Think things like losing your job, urgent medical bills, or unexpected car repairs. You never know when an emergency is going to come, nor how severe it will be, so having some cash set aside can provide some financial peace of mind.

3 more things that can help you prepare for a recession

Once you’ve implemented a plan to pay down debt and build up an emergency fund, it’s time to start taking actions that could go even further towards improving your long-term financial future:

  1. Maximise your professional value
  2. Build your portfolio for the long-term, based on your goals
  3. Implement a plan to help you profit from a market crash

Let’s take a closer look at each of these items.

Maximise your professional value

One of the biggest struggles many people have faced since the GFC has been regaining similar levels of employment and income. In addition to the loss of opportunity as many companies went under or downsized, many businesses have learned how to do more work with fewer employees and leveraged technology and automation to reduce labour needs.

Many of the fastest-growing fields need workers with skills and training that may not have even existed when you were in school, and the kind of work you currently do may not be as important or necessary as it was in the past. If that’s the case for you, it may be time to take steps to make yourself more valuable. 

This could include adding new certifications or training in your current profession to increase your value to your employer (or even a competitor). Alternatively, it might be time to explore a job change to a high-demand field while the economy is in good shape and there’s opportunity.

Sure, it can be scary walking away from the known factor of your existing job, but the best time to make a change is when you have the leverage of ongoing employment and the support of a healthy economy. Simply put, it’s easier to find a better job in a good economy than to find any job during or right after a recession.

Build your portfolio for the long term – and in a way that’s right for you

Take a look at the chart below, which shows how the market tends to drop during recessions:

Chart: author’s own. Data source: Market Index

Unfortunately, the All Ordinaries Index (ASX: XAO) was established in 1980 so we have limited data to go off when analysing the relationship between recessions and market returns. Nonetheless, we can see that when Australia entered a recession in 1982, and again in 1990 (circled in red), the share market dipped substantially.

Interestingly, the ASX fell by an even greater amount during the GFC, despite the fact Australia managed to avoid a recession. In any case, it’s completely normal for the market to fall during a recession. It’s also completely normal for the market to recover relatively quickly, too.

But one of the biggest mistakes people make during a recession (or more generally, a market downturn) is to sell their shares, often after the market has already fallen sharply, expecting it to fall even more. Sadly, this rarely results in savvy ‘buying at the bottom’ for most people. More often, the share market starts to recover before people are ready to reinvest, resulting in them missing out on the market’s recovery.

As the All Ordinaries chart above shows, the stock market does fall during recessions (and often at other times when there’s not a recession). These declines can happen quickly and unpredictably; even the best investors often don’t see them coming. Moreover, the recovery – when the share market starts going back up – is just as unpredictable. This is why you’ll never guess your way around the ‘bottom’ of the market. More likely, you’ll just sell near the bottom and sit on the sidelines, watching the market go back up, anchoring on the low price you sold at.

The takeaway isn’t to avoid shares. To the contrary, the chart above demonstrates why you should own shares, but only with a long-term time horizon. Think 5+ years or, better yet, decades. By taking a ‘buy and hold’ approach, you won’t make the mistake of selling at the worst time and missing out on the market’s recovery. 

It has often been said that the short-term risk of shares, the volatility we see during times of uncertainty, is the ‘price of admission’ to invest in the share market. If you can sit on your hands and not sell at every sign of a downturn, it’s a price you won’t have to pay. 

One of the best ways to make it easier to not sell during the next recession is to put a portion of your portfolio in low-volatility investments, such as bonds. The difference between shares and bonds is that with shares, you are part owner of a company, while a bond is a loan. 

This difference is why shares and bonds vary greatly in volatility. Simply put, the value of a bond is very easy to measure: the dollar amount of the bond plus the amount of interest it will yield before maturity. So long as the entity issuing the bond (e.g., the government or a bank) remains solvent, the bond will remain stable in value. 

Shares, on the other hand, are more speculative in nature, with people varying greatly in what they may think a particular business is worth. Add the uncertainty of a recession to the mix, and people often overreact in fear and decide to sell their shares at what eventually proves to be a bargain price. Owning bonds is a great way to hedge your risk from that volatility for the part of your portfolio you may need to sell in the next few years.

Why not just own all bonds, you ask? Well, bonds are more stable in value as an asset class, but with this comes a tradeoff with returns. Historically, bonds have been a low-return asset to own for the long term.

Sure, owning bonds will help you avoid the short-term drops, but you’ll miss out on all the long-term gains, too. Here’s a chart to demonstrate:

Chart: author’s own. Data source: Yahoo Finance and Investing.com

The chart above starts in 2013, which was the first full year of trading for the Vanguard Australian Fixed Interest Index ETF (ASX: VAF). As you can see, VAF, a diversified mix of government, semi-government and corporate bonds, proved the superior ‘loss-avoidance’ investment in periods where the ASX dipped into negative territory.

However, shares, as represented by the S&P/ASX 200 Net Total Return Index (which reinvests dividends after considering tax implications), have proven the better long-term holding, delivering an average annual return of 10.04% between 2013–2019, compared to bonds’ 4.51%.

So what’s an investor to do? Well, consider your short and long-term goals, and your risk tolerance, and invest accordingly. If you are going to need to access some of your investments starting in the next few years, it might be best to invest those funds in high-quality bonds. You may miss out on some of the upside of shares, but you won’t get caught flat-footed during a recession or market crash with all your eggs in a volatile basket of shares. 

In general, the further you are from retirement, the less you should allocate to bonds. But as you get closer to retirement (or pay for children’s education or some other financial goal), you should gradually increase your allocation of bonds. 

For younger investors, that may mean not owning any bonds just yet, so long as you can avoid panic selling when the market crashes.

Have a plan to buy during a recession

While market drops are often tied to real-world crises such as recessions that come with real-world implications, they also give us some of the best opportunities to buy shares. For this reason, it may be helpful to set aside a small amount of cash so you can act when the market drops.

What’s a reasonable amount? A number of factors can make it very different from one person to the next, including the size of your portfolio, whether you’re still working and regularly putting new money in your accounts, and how close you are to retirement or some other financial need. 

But in general, having 5% of your portfolio specifically earmarked to invest when the market falls a certain amount could be a reasonable level. That may be a little more or a little less, depending on your personal preferences as much as on any hard-and-fast rules.

It’s not a good idea to reserve all of your buying for market crashes. Taking that kind of action would cause you to have spent most of the past decade building up and sitting on your cash while the market continued to march higher and higher. But having some cash set aside for market dips can ensure that you’re able to take advantage of lower share prices, which often create some bargain buying opportunities.

When the share market falls, there are 2 milestones that investors (or at least financial commentators) often keep a watchful eye on: market corrections and market crashes. It’s generally accepted that a correction is a drop of more than 10% in the market, often measured by a broad index like the S&P/ASX 200 Index (ASX: XJO) or S&P 500 Index in the US. A correction turns into a crash when this drop reaches 20% or more. At this point, the market enters what is known as a bear market.

Now a recession and a bear market are not one and the same. While Australia has only experienced 4 recessions since 1960, the Aussie share market has recorded 9 bear markets in the same amount of time.

A Livewire article from 2019 explains that from 1960 to 2019, the All Ordinaries experienced 8 bear markets, falling by an average of 37%. Adding in the most recent March 2020 bear market takes that total to 9, while the average drop remains at around 37%.

Aside from the recent COVID-19 volatility which is still ongoing, the last notable downturn seen on the ASX was in late 2018. While the US teetered on the edge of a bear market, the S&P/ASX 200 fell 11.92% from 1 October to 21 December 2018:

Chart: author’s own. Data source: Yahoo Finance

Just 6 months later, the S&P/ASX 200 had fully recovered those losses, and investors who acted quickly during the sell-off enjoyed strong – and quick – gains:

Chart: author’s own. Data source: Yahoo Finance

This is why reserving some of your ‘dry powder’ can be a good move in the long run. Having some spare cash set aside specifically to invest in the event of a market dip can mean that you’re able to pour money into ASX shares at depressed valuations. Of course, your investment process still applies here – don’t just invest in any share – but during a market downturn, you’re likely to find many quality businesses you once deemed ‘too expensive’ trading at much more attractive levels.

As we prefaced earlier, however, it’s not a good idea to save all of your buying for market crashes. Doing so would mean that you’d be missing out on a lot of the upside potential of the share market, sitting on the sidelines while your cash earns a measly 1.5% in interest (if you’re lucky!). This is why dollar-cost averaging is a popular investment strategy that is recommended – and used – by many investors.

Dollar-cost averaging involves allocating a set amount of money to invest in shares at regular intervals (e.g., every week or month) – rain, hail, or shine. For example, let’s say you want to invest $10,000 in CSL Limited (ASX: CSL) shares. Instead of investing all of this money at once, you could choose to invest $2,000 every Wednesday for the next 4 weeks.

Over time, dollar-cost averaging means that for the same amount of money, you’ll be purchasing more shares when prices are lower, and fewer shares when prices are higher – effectively receiving the average. Dollar-cost averaging takes a lot of the emotional factors out of investment decisions and prevents the often losing battle of market timing. 

But as with most investment strategies, dollar-cost averaging has its downfalls. Since the share market has historically trended upwards over time, holding your cash to systematically invest at a later date means that you could be missing out on potential returns. Not to mention the brokerage costs you’ll incur on each trade. So again, consider what’s right for you. 

When deciding, you might want to weigh up your investment experience, how much time you have to dedicate towards research, and your temperament. In the end, you might decide to implement dollar-cost averaging exclusively during a market correction or crash, as this is when emotions and behavioural biases tend to influence your investment decisions the most.

The latter is why it’s important to have a plan in place to buy during market dips. It’s easy to say that you’ll be ‘greedy when others are fearful’. But when push comes to shove, this philosophy often goes out the window for many investors as they watch their portfolio fall lower and lower by the day. We’ve all been there, and it’s hard to know exactly how you’ll react until it actually happens. But having a proper plan set in place can help you to hold your nerve, capitalise on golden investment opportunities, and come out the other side in a much, much stronger position.

Prioritise, plan, and act

As the effects of COVID-19 flow through the economy, it is becoming increasingly likely that Australia’s 28-year recession-free run will soon come to an end. In any case, recessions are unfortunately a normal part of the business cycle in a capitalist economy.

While many Australians may sail through the next recession generally unaffected, the risk of permanent financial harm is simply too great to do nothing.

So start with a plan based on your individual situation, prioritising the following things:

  • Building up an emergency fund and paying off expensive debt
  • Maximising your professional value and prospects
  • Allocating your portfolio based on your goals, with a focus on the long term
  • Developing a strategy to invest during market downturns

Your priorities and the plan you make will be unique to you. But once you put it into action, it should help you minimise the harm from a recession, bounce back quickly, and even grow your wealth. The simple act of putting a plan into action – giving yourself something to do – will improve your prospects of coming out of the next recession unscathed.

Figures correct as of 7 May 2020. Cathryn Goh contributed to this report and has no financial interest in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. 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.