While nobody can predict the market's performance, a substantial number of forecasts are calling for limited economic growth -- particularly in the U.S. -- over the next several years. This is combined with a stock market that's stretched to lofty valuations that may be difficult to sustain.
With all of this said, it's always good to be prepared in the event a prolonged recession does come our way in the coming months. This is especially true if you're planning to retire or if you've experienced a recent loss or change in your regular income.
Here are four ways you can prepare for the next recession.
1. Reassess your risk tolerance
Given the stock market's outperformance in 2021, it's easy to feel like these returns are normal and expected, which can lead one to take on more risk than they would otherwise.
For example, say you started the year with a portfolio made up of 75% stocks and 25% bonds, reflecting an aggressive appetite toward risk. But now, at the end of the year, you might be closer to 80% stocks and 20% bonds due to the S&P 500 and its generous 20% return for the year.
You might feel like there is more room to run in stocks, but by maintaining this position, you're also exposed to significant future losses if the market were to go south for an extended period.
If large losses are something you fear, you should reassess your ability, willingness, and need to take risks. A portfolio that has stretched to 80% stocks may have a higher level of stock market risk than you're willing to take.
This is an opportune time to revisit your ideal asset allocation (the ratio of stocks to bonds and other assets in your portfolio) and to determine if your portfolio has run awry. If so, it's the perfect time to give this some thought and decide how much risk you're truly willing to take.
2. Rebalance on a fixed schedule
Instead of rebalancing any time the market goes up, try to find a reasonable schedule to go in and rebalance your portfolio. This ensures that you're taking non-emotional steps to bring your portfolio risk back to where you originally set it.
Rebalancing is simply the act of bringing your investments back in line with their original weightings in your portfolio. If stocks have done relatively well over the preceding period, it's likely you'll sell some stock and buy other assets. If stocks have plunged, you'll use other assets to buy stocks at a discount.
You can pick any schedule, though rebalancing semi-annually or even annually seems to work well for most people. These schedule points are easy to remember and usually are illuminated by calendar events, like the new year.
3. Turn off the financial news
Gluing your eyes to financial news programs is more likely to cause you to impulsively trade than it is to make you wealthy. Much of what you'll see on television is likely to play on the emotions of fear or greed, which may lead to buy or sell decisions that may or may not align with your overall financial plan.
The financial game is largely about keeping your focus on the factors you can control. Among them: saving at regular intervals, keeping costs as low as possible, and sticking to your pre-determined asset allocation. These simple actions, combined with a globally diversified portfolio, represent the most effective ways to accumulate long-term wealth.
It's been said before, but doing well with your finances is as much about keeping your emotions in check as it is about how much money you make or how you invest. Staying focused on your plan is a lot more difficult when stock prices are falling, but the evidence has shown us that those who stay the course are likely to come out ahead in the long run.
4. Consider a more conservative asset allocation strategy
Let's first establish what you shouldn't do. It's probably not in your interests to try to predict the market over any timeframe, but it is a good idea to periodically check on the level of risk you're taking in your portfolio. Given that stocks have run up recently, there's a strong possibility you're exposed to more risk than you realize.
Based on your ability to take risks, there's never been a better time to readjust -- even taking your stock allocation down from 80% to 65% can do a tremendous amount in terms of reducing the probability of catastrophic loss.
In the end, no matter what you do, be sure that you've given adequate consideration to the riskiness of your portfolio as a whole.