The Looming Economic Collapse

Many Americans are pessimistic about the future of the U.S. economy. According to a Harris Interactive survey, 45% believe the economy is declining. Unease is equal across the board (East, Midwest, South, and West), with 56% of Americans "worried" about the economy.

Coupled with nationwide concerns about a looming economic collapse is concern about personal finances. According to Harris, one-third of Americans say that compared to one year ago, their personal finances are worse. More than half of all Americans are worried about their financial situation.

And that's with the market at new highs!
Despite superb stock market returns (here and especially abroad), there's an increasing sense of pessimism. I'm not here today to predict whether it's warranted -- whether we're in for a recession or anything resembling a recession.

That's mostly beside the point. If we hit an economic trough, average folks like us can't do much about it anyway.

What we can do, though, is prepare our finances. Whether you're in the faction that feels like finances have worsened or you're swimming right along, you must put together a plan to weather tough times.

The financial preparedness plan
The only way to ensure financial stability through a recession or bear market is to have a plan. It needn't be complex. Start with the two basic things everyone can do, regardless of financial situation:

1. Reduce debt.
2. Start saving.

Get rid of high-cost consumer debt. While mortgages and tax-deductible student loans are "good debt," credit card debt will considerably increase your vulnerability during a recession.

Obviously, you'll want to pay down all the bad debt you can, but Robert Brokamp, advisor of Motley Fool Rule Your Retirement, suggests a debt-to-income ratio of no more than 2.5. That means total debt is up to 2.5 times gross annual income. (If you make $50,000 a year, you should not have more than $125,000 in debt.)

Next, start saving. Ideally, you should save 10% to 20% of your paycheck. The easiest way to do so is by automatically contributing to an employer plan or Roth IRA (particularly if your company matches your contributions). If you're picking mutual funds, stick with a low-cost fund company (such as Vanguard or Fidelity) that doesn't charge loads and keeps expense ratios below 1.2% or so.

Now, 10% to 20% of your paycheck may intimidate you. Remember, that's the ideal -- at the very least, find $50 a month you can put in your savings account. (If you need ideas on how to save, here are 50 Foolish tips.)

Choose your investments wisely
If you're more than 10 years from retirement, a well-diversified portfolio of large-cap and small-cap stocks will increase your potential for superior returns. And if you don't have time to pore over 10-Qs (or -Ks), the easiest choice is a total stock market fund or S&P 500 index fund such as the Vanguard 500 Index Fund. Then tailor your portfolio to your own timeline and appetite for risk.

How much risk?

Robert explains that "On average, the U.S stock market has gone up more than two out of every three years, but unfortunately, the market doesn't follow a 'two up, one down' pattern." Sometimes there are a few down years in a row, and those down years will get you. Remember the period between March 2000 and October 2002? The S&P 500 was cut in half, which means that after a 50% drop you had to earn 100% just to break even.

Volatility is inevitable in the short term. The solution? Asset allocation and asset location.

Practicing smart asset location can add quite a bit of after-tax value to your portfolio. For example, some investments have built-in tax advantages -- but those advantages can be nullified if the investments are held in a tax-deferred retirement account like an IRA. Smart asset allocation means having a well-diversified portfolio and the right holdings in the right places, which will lower risk and increase returns.

Recession-proof your portfolio
A diversified portfolio should contain four core asset classes: U.S. stocks, international stocks, real estate investment trusts (REITs), and commodities. If one class takes a hit, such as the housing market, your portfolio will be anchored by the remaining three.

Let's look at an example portfolio:

The Foolish bottom line
No one can predict the future of the economy. But if you can predict your level of preparation, you don't need to.

Reduce your debt, start saving like mad, and allocate your assets intelligently. That'll get you on the path to disaster-proofing your finances.

Start now -- while you have plenty of time -- and you'll avoid a gruesome retirement. And don't worry, it's never too early (or too late) to start saving for retirement.  

For ideas on reducing debt, savings plans, model portfolios, or specific stock or fund recommendations, let Robert's Rule Your Retirement service guide you through planning for future expenses, asset allocation, strategies for deferring taxes, and more.

You can try the service free of charge for 30 days, and you'll have free reign of everything we've ever published with no obligation to subscribe. Click here for all the details.

Claire Stephanic does not own shares of any companies mentioned in this article. Microsoft and Vodafone are Motley Fool Inside Value recommendations. The Fool has a disclosure policy.