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How to prepare for a recession: 5 steps

How to prepare for a recession: 5 steps

How to prepare for a recession in 5 easy steps

As I write this in early 2018, the risk of the economy falling off a cliff is pretty small. Job growth is robust, employment is down, consumption is healthy, inflation is low but steady. We're living in an economy that many would say is just right. Not too hot, not too cold. 

That's exactly why it's a good time to start thinking about a plan for when things aren't so perfect. We're living through one of the longest economic expansions in history, and although the chance of recession is still slight, every day it rises just a little more. It's time to start what to do before a recession, and thinking about how to deal with it when it arrives. 

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Preparing for a Recession: Start with the Right Mindset

Hopefully this doesn't seem too alarmist. I am invested for the long haul, and I am sure you've also prepared a portfolio that you can be confident in during good times and bad. Hopefully, you've also run it through Personal Capital's investment checkup tool to ensure your portfolio reflects your risk profile. Since I have done all of that, I don't think there's any reason to try to time the market. Every time I've tried to predict anything, I've failed. I am not trying to do that here.

We may not know when the next recession will come, but one thing's for certain: it's easier to plan for it BEFORE it begins, when times are still good. Here's my plan.

1. Preparing for a recession in 2018: Pay off debt

Now that we're nearing the peak of the economic cycle, the tendency is to borrow more. This is the time when people buy houses, cars, get new credit cards, take out HELOC's and generally spend freely. That's exactly the opposite of what they should be doing. With the stock market and real estate market at all time highs, risk is expanding significantly.

Here's a good rule of thumb. If you can cut your income by 25% and still service all of your debt without needing to sell anything, then you're fine. Otherwise, I would suggest deleveraging and paying off your highest interest loans (whatever they are). Eliminating periodic payments will only make it easier to make it through a recession unscathed. 

At the very least, don't take out any new loans, credit cards, or mortgages, unless you are consolidating existing debt into a lower interest loan. It can be difficult to find extra money to pay off debts, but avoiding new loans will help keep things under control. 

It's not all work. Long term debts like mortgages and student loans will naturally decrease in balance over time, helping you to de-lever without changing anything at all.

If you do nothing else at all, no new debt. This will make it significantly easier to survive a recession. There is one small exception I will detail below.

2. How to prepare for a recession: Save for emergencies

This may seem patently obvious, but saving is probably the best way to plan for a recession. If you haven't been saving as much as you want to, like me, now is the time to save a lot more. 

Having a 3-6 month emergency fund is a great first step to strive for. So many other bloggers have talked about preparing for a recession with an emergency fund that I'm not going to take the time to go into the details of why this is important. Trust me, it is.

It's also challenging to prioritize and get started. Once I've saved a little, my tendency is to transfer and spend it.  A method I have used in the past to build up a small nest egg is the "ATM saver" route. Every week, or every two weeks, withdraw $40-$80 from the ATM and keep your stash somewhere that's hard to reach (locked in your desk at work, for instance).

If you're consistent, you'll have $2k-$4k at the end of the year that you can deposit in a savings account for the beginnings of your emergency fund. Just to be clear, I wouldn't advise doing this unless you have a safe place to save the money. Duh.

3. How to financially prepare for a recession: Get ready for opportunities

Saving isn't just for emergencies, it's also for opportunities. Right now, stocks, bonds, real estate and seemingly everything else are at or nearing all time highs across the globe. If there is a global recession, everything will be cheaper. I'm trying to save a little extra on top of my emergency fund so that I'll be able to take advantage of fire sale prices to buy.

When I was describing #1 above (No New Debt), I noted there was an exception. If you have the discipline NOT to use it, now is a good time to apply for margin on your main portfolio. This way when asset prices are (hopefully) very attractive, you will have the ability to act even if you aren't able to save as much as you would like for dry powder. Keep in mind that any debt is a dangerous magnifying glass on your returns, so I would only advise doing this if you are a highly experienced investor... and you wait until asset prices are significantly lower to utilize margin.

If everything is going right, you should be tracking your investable cash in Personal Capital for free, and it should be going up and to the right. I don't know whose $157,000 this is, but it's looking ready for a dip in prices!

4. Prepare for a downturn: Rebalance into lower risk funds

This is fairly obvious, but now is a great time to rebalance after the gains of 2017. Because it was such a good year, my personal portfolio is now even more heavily weighted towards the riskiest assets that have performed the best during the past year, like emerging markets and US stocks. My bond funds have done very poorly, in comparison.

This is why I will need to focus my fresh investments for the year on my less risky bond funds. I might even need to sell some of my most over-performing emerging markets index funds, but I will probably try to avoid this to avoid paying taxes on the gains. One thing I know for sure: the American economy has been going strong for 9 years, and that is nearing the record long for an expansion.

Here you can see my current and target allocations in Personal Capital, with the international stocks clearly over-allocated.

5. What to do before a recession: Take fewer risks

Whether you are investing, making career moves or planning your vacations over the next several years, my advice is to take fewer risks. I'm buying safer index funds, sticking with the job I am already secure in, and planning for less spending. I figure that every small sacrifice I make now will prevent a big sacrifice or adjustment down the road.

It's not just risk avoidance... it's about avoiding risk at the wrong time. I don't want to be the person who buys a house in 2007, or goes all in on tech stocks in 2000. If I can avoid awful risks, build up a nest egg, and stay nimble enough to be flexible in a downturn, I can be prepared to buy distressed assets when they become distressed.

What not to do when you are getting ready for the next recession

I feel confident about my plans, but I am also confident about what I'm not doing. I'm not buying gold and stashing it under my mattress. I'm not loading up on bitcoin. I'm not "prepping", lol. Recessions are awful and frustrating, but they're not the end of the world (or the US economy), and there's no sense pretending like they are.

Conclusion

Like I said at the start, I don't think a global recession or downturn is imminent. But, there will be one at some point. I'm starting to plan now. 

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