How to prepare for a recession

How to prepare for a recession

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

Man standing with an umbrella over his head with a sad face whilst it rains.
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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.

Traditionally, recessions are 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.

Australia was the only major economy to avoid a recession in the global financial crisis (GFC), but the country was unable to escape the coronavirus-induced downturn. Gross domestic product (GDP) fell 7% in the June 2020 quarter, the most significant decline since records began in 1959. This followed a 0.3% contraction in the March 2020 quarter, which was hit by bushfires and then the pandemic. 

Around 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. Nonetheless, many Australians found themselves struggling financially. 

So, let's look at what a recession is and the steps you can take to protect yourself and your family from the potential consequences.

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 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.”

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 said the downturn is over. 

According to the Parliament of Australia, there were four recessions in Australia between 1960 and the onset of the pandemic. They occurred in 1961, 1974-75, 1982-83, and 1990-91. To this, we can add a fifth – the 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.

The first effects of the pandemic were apparent in the March 2020 GDP figures. Over the year to March, GDP growth was 1.4%, well below the long-term average of 3.4%. 

Things worsened considerably in the June quarter when GDP fell 7% as the pandemic and travel restrictions continued to impact economic activity. Household consumption expenditure fell a record 12.1% in the June quarter and 2.6% for FY20, the first annual fall in recorded history.

Australia’s unemployment rate hit a high of 7.5% in July 2020 and has been mainly trending downwards ever since. While we’re told that the economic recovery from coronavirus is complete, Australia is emerging from the crisis in 2022 with skills shortages in the labour market, supply chain issues caused by the Omicron variant, and greater debt. 

The global economy has become less congenial as relationships with China have deteriorated, dislocating trading and investment networks. 

China was Australia’s largest two-way trading partner for many years, but since 2020, it has imposed trade restrictions on many Australian exports, including beef, lobster, cotton and timber, and placed hefty tariffs on wine and barley.  

This certainly paints a sobering picture of our economic future. So, with Australia regrouping after its first recession in nearly 30 years, how financially prepared are you?

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 so necessary.

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

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 to build wealth and lead to an overall improvement in one’s long-term financial position – used responsibly, of course.

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

Here’s an example. The average credit card interest rate is around 20%. 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 $1,861 over 7.9 years to pay 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 choose to tackle this in different ways. Naturally, everyone is different, so decide what works best for you. 

The two 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.

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 the debt is under control, another step you may want to take is to reduce your credit limit. This can help you avoid falling into the same trap of living beyond your means.

Build up an emergency fund

Now, 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. 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, and other financial obligations like loans 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 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 the ‘six months of savings’ mark. That’s okay. Just set the goal and put a plan in place to reach it. This might involve setting up an automatic transfer of money from your wage straight into your emergency fund account.

Once you get to 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.

An emergency fund will not deliver much of a return on your savings because interest rates are so low. But remember, these savings aim to be there in an emergency, not to get sexy returns. 

Sure, 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 share market volatility – not to mention that it 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 if something unexpected, such as losing your job, urgent medical bills, or unexpected car repairs. You never know when an emergency will happen or how severe it will be, so having some cash set aside 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 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

Many people have struggled to regain lost levels of employment and income in the aftermath of the GFC and through the pandemic. 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 labour needs.

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 take steps 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.

Sure, 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 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 after a recession.

Build your portfolio for the long term

The All Ordinaries Index (ASX: XAO) was only established in 1980 so we have limited data when analysing the relationship between recessions and 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, it 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.

But 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 falls during recessions (and often at other times when there’s no 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. 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, 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.

Diversify your portfolio

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.

Shares, on the other hand, are more speculative, 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 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? Well, 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, it might be best to invest those funds in high-quality bonds. 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 an investor is 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), consider gradually increasing the bond allocation.

For younger investors, that may mean not owning any bonds at all, as long as you can avoid panic-selling if 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? Several 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 generally, having 5% of your portfolio specifically earmarked to invest when the market falls 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 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 bargain buying and dollar-cost averaging opportunities.

Market correction or crash?

When the share market falls, there are two milestone events that investors (or at least financial commentators) 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 (INDEXSP: .INX) 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 the same. While Australia has only experienced five recessions since 1960, the Aussie share market has recorded nine bear markets in the same period.

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

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 can mean you can pour money into ASX shares at depressed valuations. 

Of course, a diligent investment process still applies here – don’t just invest in any old share. But during a market downturn, you’re likely to 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 while your cash earns a measly 1.5% in interest (if you’re lucky!). 

Dollar-cost averaging

This is why dollar-cost averaging is a popular investment strategy that many investors recommend – and 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 sum, you could choose to invest $2,000 every Wednesday for the next four 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 many 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, 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, you might want to weigh your investment experience, how much time you dedicate to 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 essential to have a plan 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 happens. But having a proper plan set 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

COVID-19 has taken a sledgehammer to the Australian economy, pushing it into its first recession in nearly 30 years. While this is fiscally painful, it is important 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 great 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. 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.

Last updated June 2022. Katherine O'Brien contributed to this report and has positions in CSL Ltd. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended CSL Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. 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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