Tip 1: Start thinking about it now
The most common mistake people make isn’t necessarily being financially ready for a recession, it’s being mentally prepared for one. People tend to overestimate the upside, and underestimate the downside risk of their investments. This may be compounded by the comfort we all feel after a 10 year upward trending stock market. When we’re comfortable, it makes us susceptible to panic. Think critically now “What if I woke up tomorrow and half my investment portfolio was gone?” If your answer is, you’d sell now to stop the bleeding, consider reviewing the amount of risk you’re taking and make sure that’s in line with the amount of risk you’re taking with your investment strategy.
Tip 2: Save now
Don’t overextend yourself when times are good. It could be a recession, or it could be another unforeseen life changing event. Either way, it’s much harder to cut spending than to keep it steady – so do what you can to live below your means and save (or paydown debt if you have any) now. The choice may not be yours at some point.
Establish an emergency fund of about 6 months of expenses. I generally recommend 3 months in your checking and 3 months in a money market account earning some interest. If your source of income can have erratic cash flows, or is particularly susceptible to recessions such as construction, cars, or luxury goods, consider keeping extra in your emergency fund.
Once you have your emergency fund in place, you can go out and make other investments with extra cash and know you won’t need to sell your investment in a down market to meet your immediate living expenses.
Tip 3: Review your risk and diversify your investments
“Everyone has a plan until they get punched in the mouth.” This is true with investing too. It can be easy to stick to your investing plan when the stock market is up, but is much more difficult during a down market. If you haven’t stress tested your portfolio, I suggest doing so now to make sure you are comfortable with the amount of risk you’re taking. You should diversify your investments based on the amount of risk that makes sense for you. Bonds can feel like a boring drag on your investments when the market is going higher, but you will be grateful you have them when a recession comes.
Those that did the right thing and weathered the storm in the last recession, may assume they will be able to do the same thing next time. The difference is now you are 10 years closer to needing that money. If you don’t adjust the risk level in your investments over time, you could be taking more risk than is suitable for you. Unfortunately, most people don’t find this out until the stock market goes down significantly and at that point, it is too late, so review your risk regularly.
Tip 4: Rebalance your portfolio regularly
In addition to periodically reviewing the risk level in your target portfolio, you should also be rebalancing your portfolio. If you don’t do this, over time your portfolio gets off track of its intended risk profile. When the stock market increases over time, stocks take up a larger percentage of your portfolio. This increases the risk of your portfolio when you should be keeping it consistent (and even reducing it over time).
As a bonus, a consistent rebalancing strategy is also a good way to follow the first rule of investing: buy low and sell high. By rebalancing, you are selling a small piece of your portfolio that has performed well, and using that money to buy some of the investments that have fallen out of favor with Wall Street. This essentially creates a disciplined buy low, sell high strategy for your portfolio when you do this regularly. I suggest doing this quarterly.
If you haven’t reviewed the risk or rebalanced your portfolio in the past 6 months, you’ll want to do this sooner than later.
Tip 5: Stay the course
Once you’ve established an emergency fund, invested the rest, diversified your investments, and aligned your portfolio with the amount of downside risk you can tolerate, you’re still not in the clear. You need to stay the course when the next recession happens.
Preparation is only half the battle – the people that got hurt the most in the Great Recession (2008-2009) were those that sold their investments during the downturn. It took 4 years for the stock market to recover from the Great Recession. If you need the money you have invested within the next 5 years, you shouldn’t be investing it heavily in the stock market. If you don’t need it within 5 years, you shouldn’t be worrying about short term moves in the stock market, so stay the course!