Ever wonder why economists can't predict recessions? Maybe it's because they're optimists. When times are good, it's human nature to believe the prosperity train will just keep on rolling. But unfortunately, recessions happen, whether or not we see them coming. And the best time to prepare is always right now.
The last recession, known as the Great Recession, started in the U.S. in December of 2007 and lasted until June of 2009. During that time, the subprime mortgage industry collapsed, housing prices crashed, U.S. real gross domestic product declined by 4.3%, and unemployment shot up from 5% to 9.5%. American households lost roughly $16 trillion in wealth, thanks to job loss, housing value declines, and a 57% drop in U.S. stock prices.
Those are depressing statistics, to be sure. Here's hoping the next downturn is shorter and milder. And since hope alone doesn't do a great job of protecting wealth, here are five actions you can take to prep your finances.
1. Pay down debt
Debt always reduces your financial flexibility. Unemployment will rise during a recession, which increases the chances you'll face a loss or decrease of income. If that happens when you're servicing a bunch of credit card debt, you might miss payments. And that would kick off an avalanche of fees and higher interest charges.
The takeaway? Work to pay off your credit card debt now while you're enjoying that regular paycheck.
2. Rebalance your portfolio
Rebalancing your portfolio is the process of selling some of your investments to purchase others, with the goal of achieving a specific asset allocation. Asset allocation is the composition of your portfolio across different asset classes, like stocks, bonds, and cash.
Unless investing is your hobby, you probably haven't paid much attention to your asset allocation since you set up that 401(k). Now's the time to take a look. Here's why. Stocks and stock funds grow in value faster than bond and bond funds. A portfolio that's left alone too long can easily end up being too heavily weighted in stocks. That's problematic because it's risky, particularly in recessions, when markets are volatile.
Advisors recommend the rule of 100 for a conservative approach to asset allocation. Subtract your age from 100 and the result is the percentage of stocks you should hold in your portfolio. So at age 55, your balanced portfolio consists of 45% stocks and 55% bonds and cash. Review your holdings today and make a plan to rebalance things if you're sitting on too many stocks.
3. Trim exposure to risky investments
If you have to sell off stock positions to increase your bond holdings, get rid of your riskiest stuff. Large positions in individual stocks are risky. So are mutual funds in niche categories like microcap companies. Increase your positions with companies that provide products and services people use daily, like consumer staples, healthcare, and utilities. Dividend-paying stocks tend to be resilient in volatile markets as well.
4. Streamline living expenses
It's better to trim your living expenses when it's a choice and not a necessity. If you keep a budget and track your spending, you're already ahead of the game. If you don't, now's the time to start. Pore over your banking statements and look for ways to simplify your finances. That could mean consolidating and paying off debt, canceling subscriptions you don't use, changing your weekly date night to biweekly, or all of the above.
5. Increase contributions to your emergency fund
Cash is your friend in a recession. If you lose your job, cash on hand pays your bills. Without it, you borrow on credit cards or -- worse -- you cash out your 401(k) savings when you should be rolling them into an IRA.
As you streamline your expenses, direct the savings into a cash emergency fund. Keep saving until the balance is enough to cover six months of your living expenses. Once you reach that balance, you can redirect those contributions to your retirement accounts.
Bolster your finances
Riding the prosperity train is fun, but eventually we all get kicked off. Take steps now to bolster your finances and insulate yourself from the worst impacts of a recession.