How to prepare for a recession

Recessions are an economic reality. They're also challenging to predict with any precision. They typically start before anyone realises they're happening and end before economists have enough data to know they've finished.

Recessions tend to be relatively short-lived. But the impacts can be severe and long-lasting, causing permanent financial damage to those who may not have the means or financial security to ride out the short-term challenges.

Taking steps to protect yourself and your family from the potential consequences of a recession is essential. Let's look at what a recession is and what you can do today to ensure you're as prepared as possible.

What is a recession?

A recession is a slowdown of economic activity, as determined by negative GDP growth lasting two consecutive quarters or longer. 

The United States National Bureau of Economic Research has a more expansive definition of a recession¹: "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."

Beyond the textbook definition, a recession results in real economic hardship or harm. 

A return to economic growth marks the end of a recession but not a full financial recovery to pre-recession levels. In other words, people affected by a recession often continue to struggle long after the economists have called the downturn over. 

A quick recap on recessions in Australia

There were four recessions in Australia between 1960 and the onset of the COVID-19 pandemic. They occurred in 1961, 1974-75, 1982-83, and 1990-91. To this, we can add a fifth – the short-lived coronavirus-induced recession of 2020.

Interestingly, before the pandemic, Australia held the world record for the most prolonged period without a recession – 29 years from June 1991. Unfortunately, COVID-19 brought this run to an end.

Gross domestic product (GDP) fell 7% in the June 2020 quarter, the most significant decline since records began in 1959. Nonetheless, Australia reported positive GDP for each quarter from late 2020, with the exception of the September 2021 quarter. 

About one million Australians were out of work at the height of the COVID-19 shutdowns, although the Federal Government's JobKeeper program provided a lifeline and buoyed official unemployment figures. 

However, inflation and rising interest rates have darkened the outlook, with some predicting a recession in 2023. On the plus side, most predictions are for a smaller-sized dip in economic activity rather than a particularly dire recession.

Others point out that the consecutive interest rate hikes in 2022 and 2023 have increased the likelihood of recession, with indicators rising. These include a faltering property market and potential foreclosures. Also, reduced consumer spending can push the economy into negative growth, so the RBA risks taking us closer to recession with further rate rises. 

2 ways to beat the recession blues

When it comes to preparing for an unexpected financial downturn, there are two things you can do that will supercharge your ability to ride it out and emerge unscathed on the other side:

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

Let's take a closer look at why these preparations are necessary.

Pay off high-interest debt ASAP and keep other debt to a minimum

Debt isn't always a bad thing. It can be a terrific 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 considered 'good debt'. Ideally, they will help build wealth and improve one's long-term financial position – used responsibly, of course.

In contrast, debt that does not benefit your financial position can be damaging and costly, especially during a recession when resources are more limited. For instance, using a credit card to buy items when you don't have the cash available and not paying off the credit card debt at the end of the billing period is financially destructive.

Here's an example. The average credit card interest rate is about 20%². 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 calculator³ tells us you'll spend $1,861 over 7.9 years paying off that $1,000 purchase.

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

• You will spend less money to acquire things (and buy fewer items 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 tackle this in different ways. Everyone is different, so you decide what works best for you. 

The 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're maximising your savings on interest.

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

Once you have your debt under control, another step you can take is reducing your credit card limit. This can help you avoid falling into the same trap of living beyond your means.

Build up an emergency fund

This is an obvious step, and it's one that you've likely heard of before. What may not be as clear is how much you need to save for your emergency fund. There isn't a single answer to this question that suits everyone, but there are some pretty good basic guidelines to follow. 

Financial experts recommend setting aside at least six months' worth of living expenses. This means enough money to cover housing and utilities, necessities like food and personal care items, and other financial obligations like loans and insurance payments. So, take the time to work out how much it costs you (and your family) to get by in a typical six-month period.

The next step is to build up your safety net gradually. It may take a year or even longer to save enough cash to reach six months of living costs. That's okay. Just set the goal and put a plan in place to achieve it. This might involve automatically transferring money from your wage deposits straight into your emergency fund account.

Once you reach the six-month target, keep saving with the goal of one year in savings – particularly if you own a home or have dependants living with you. Financial liabilities are higher in these situations, and it's good planning to have the resources at hand to deal with the unexpected.

You should stash your emergency fund in a high interest rate account. With interest rates rising, savings accounts are again starting to deliver reasonable returns. But remember, these savings are for emergency use, not sexy returns. 

So stick it in the bank account that will deliver the highest interest. Avoid investing your emergency fund, as this ties up your capital and exposes it to sometimes extreme short-term share market volatility. It also defeats the entire purpose of having an emergency fund in the first place. 

An emergency fund is about creating a financial safety net so you don't have to borrow money or sell assets like shares if something unexpected happens, such as losing your job, urgent medical bills, or unexpected car repairs. Setting aside cash for these scenarios can provide financial peace of mind.

More ways to 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 toward improving your long-term financial future:

1. Maximise your professional value
2. Build your investment 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

Job opportunities sink as recession-hit companies go under or downsize, with many businesses learning how to do more work with fewer employees and leveraging technology and automation to reduce their labour force.

Some of the fastest-growing fields need workers with skills and training that may not have even existed 10 years ago, and the work people 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 make yourself more valuable.

This could include adding new certifications or training in a current profession to increase your value to an 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.

Walking away from an existing job can be scary, 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, finding a better job in a good economy is easier than finding any job during a recession.

Build your investment portfolio for the long term 

As the S&P/ASX All Ordinaries Index (ASX: XAO) was established in 1980, we have limited data when analysing the relationship between recessions and share market returns. Nonetheless, the share market dipped substantially when Australia entered a recession in 1982 and again in 1990.

Interestingly, the ASX fell by an even more significant amount during the GFC, although Australia managed to avoid a recession. Of course, the ASX dropped again with the onset of COVID-19. In any case, it's normal for the market to fall during a recession. And historically, it has also been customary for the market to recover relatively quickly.

One of the biggest mistakes people make during a recession (or, more generally, a market downturn) is to sell their shares – often straight after the market has fallen sharply, expecting it to drop even more. 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 recovery.

The stock market generally falls during recessions (and often at other times when there's no recession). These declines can happen quickly and unpredictably, and 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. On the contrary, there are many reasons why you should own shares, but only with a long-term time horizon. Think five-plus years or, better yet, decades. Taking a 'buy and hold' approach means you won't make the mistake of selling at the worst time and missing out on the market's recovery. 

It is often said that the short-term risk of shares and 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 way 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 straightforward 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 (for example, a government or bank) remains solvent, the bond will remain stable in value.

On the other hand, shares are more speculative, with significant variance in what people 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 a trade-off in returns comes with this. Historically, bonds have been a low-return asset to own for the long term.

So what's an investor to do? Consider your short- and long-term goals and risk tolerance, and invest accordingly. If you need to access a portion of your investments within the next few years, investing those funds in high-quality bonds might be best. 

You may miss out on some upside in 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. 

Generally, the further you are from retirement, the less you should allocate to bonds. For younger investors, that may mean not owning any bonds at all, as long as you can avoid panic-selling if the market crashes. 

You might consider gradually increasing your bond allocation as you get closer to retirement (or some other financial goal, such as paying for your children's education).

Have a plan to buy during a recession

While market drops are often tied to real-world crises such as recessions and pandemics 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? Several factors can make this very different from one person to the next, including the size of your portfolio, whether you're still working and regularly putting new money into your accounts, and how close you are to retirement or some other financial need.

Generally, having 5% of your portfolio specifically earmarked to invest when the market falls by a certain amount could be reasonable. 

It's not a good idea to reserve all of your buying for market crashes. Taking that action would have caused you to spend most of the past decade sitting on your cash while the market continued to march higher and higher. 

But having some cash set aside for market dips can ensure you can take advantage of lower share prices, which often create bargain buying and dollar-cost averaging opportunities.

When the share market falls, there are two milestone events that investors (or at least, financial commentators) keep a watchful eye out for. They are 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 (INDEXSP: INX) in the United States. A correction turns into a crash when this drop reaches 20% or more. At this point, the market becomes what is known as a bear market.

Recession vs. bear market  

Now, a recession and a bear market are not the same thing. While Australia has only experienced five recessions since 1960, the Aussie share market has recorded nine bear markets in the same period.

A bear market occurs when the share market falls 20% or more off a recent peak. A recession, on the other hand, involves two consecutive quarters of negative GDP growth. 

The most recent bear market in Australia was experienced in early 2020 with the onset of the COVID-19 pandemic. Australia experienced its first recession since 1991 later that year. 

Aside from COVID-19 volatility, the last notable downturn seen on the ASX was in late 2018. While the US teetered on the edge of a bear market, the ASX 200 fell 11.92% between 1 October and 21 December 2018.

Just six months later, the ASX 200 had fully recovered those losses, and investors who acted quickly during the sell-off enjoyed strong – and quick – gains.

This is why reserving some of your 'dry powder' can be a good move in the long run. Setting aside some spare cash to invest specifically during a market dip means you can pour money into ASX shares at depressed valuations. 

Of course, a dynamic investment process still applies here – don't just invest in any old share. But during a market downturn, you'll likely find quality businesses – once deemed 'too expensive' – trading at more attractive levels.

As we discussed earlier, saving all of your buying for market crashes is not a good idea. Doing so would mean missing out on the share market's upside potential, sitting on the sidelines even if your cash earns better returns in a savings account than it has in years gone by.

This is why dollar-cost averaging is a popular investment strategy that many investors use.

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

Over time, dollar-cost averaging means that for the same amount of money, you'll be purchasing shares at a range of price points, effectively receiving the average. Dollar-cost averaging takes many emotional factors out of investment decisions and avoids the often losing battle of timing the market.

But as with most investment strategies, dollar-cost averaging has its downfalls. Since the share market has historically trended upward over time, systematically holding your cash to invest at a later date means 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, weigh your investment experience, how much time you can dedicate to research, and your temperament. In the end, you may choose to implement dollar-cost averaging exclusively during a market correction or crash, as this is when emotions and behavioural biases influence your investment decisions the most.

The latter is why it's essential to have a plan to buy during market dips. It's easy to say 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 portfolios 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 happens. But having a proper plan in place can help you hold your nerve, capitalise on golden investment opportunities, and come out the other side in a much stronger position.

Prioritise, plan, and act

Rising interest rates threaten to push Australia into its first non-COVID recession in 30 years. While this is fiscally painful, it is essential to remember that recessions are a normal part of the business cycle in a capitalist economy.  

While some Australians may sail through reasonably unaffected by a recession, the risk of permanent financial harm is simply too significant to do nothing to prepare for the next one.

So start with a plan based on your 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 implement it, it should help you minimise the harm from a recession, bounce back quickly, and even grow your wealth. 

Putting a plan into action – giving yourself something to do – will improve your prospects of coming out of the next recession unscathed.