As a millennial, I always feel the impending doom of a recession looming in the back of my mind. I turned 18 in 2008, so for the first years of my adulthood, I was away at college studying finance while witnessing the utter devastation that recessions cause families. Fast-forward to January 2020, and I would have told you that I expected another mild recession just like everyone else that follows the economy, but I never expected anything like this.
After years of comparing the economic conditions of the Great Recession to the Great Depression, it was comforting to think that we probably had a long time to wait until we saw another catastrophic jolt to the economy. Sure there would be ups and downs, but nothing like the Great Recession, right?
Well, coronavirus had other plans, and just like that all of the trauma we millennials experienced in 2008 has risen to the surface again. The thought of going through this every decade is anxiety-inducing, to say the least, but if it’s taught us anything it’s how incredibly important it is to build healthy finances so you aren’t devastated every time one of these ‘Great Recessions’ pops up.
If you’re looking to create a financial plan before the next recession, you aren’t alone. These are the 3 steps you should take to make a good financial plan for a recession so you don’t lose all of your money, and can even come out ahead.
1. Build an Emergency Savings
I seriously can’t stress the importance of this enough. It’s probably the least “sexy” thing you can do with your money, but the most critical one if you want to adequately plan for a recession. That’s because recessions = job losses. Maybe your job wasn’t affected this time, but that doesn’t mean you’ll be spared during the next recession.
In 2008, the high rate of mortgage defaults caused jobs at banks and insurance companies to be severely affected. In 2020, social distancing has caused the airline, hospitality, and service industries to be hit hardest. What causes the recession affects which jobs are the first to go, and next time, it could be yours.
If this happens to you, your emergency savings will be a Godsend. It’ll allow you to pay all of your bills, put food on the table, and keep your sanity and Netflix subscription. If you want to focus on getting a new job and getting back on your feet as fast as possible, you can’t be spending all of your time trying to make ends meet. Instead, you’ll need to be focusing on what your next move is and how you can land a new job. Your emergency savings gives you the stability needed to shift your focus from what’s happening right now, to what you can do to build your future.
As a good rule of thumb, you should have 3-6 months of expenses saved in your emergency savings and keep it in a high-yield savings account. The more responsibilities you have like loans, kids, or a mortgage, the closer you should be to 6 months of savings. A high-yield savings account is the best place to keep your money because they pay you about 20 times more than traditional savings accounts just for keeping your money in them. Who doesn’t want more money for doing the same thing?! If you need more guidance on how to set up your emergency savings, this post has all of the info you’ll need.
2. Invest in the Stock Market
The second step to building a solid financial plan for the next recession is to start investing. The S&P 500 is widely regarded as the best indicator of how the overall stock market is doing. In 2008, the S&P 500 entered a bear market, which means that stock prices were declining. After prices began to fall, it took 5 years for the S&P 500 to reach its pre-recession price of around $1,500 per share.
Since then, the share price for the S&P 500 index has more than doubled. So even if you lost money in the 2008 crash, as long as you held your investments, you made it all back in 5 years and have more than doubled your money since.
The bear market for the Coronavirus Crash began in early March and was the fastest fall of global stock markets in financial history. It was short-lived though, and the drop ended in April. Since then, stock prices have risen to above pre-Coronavirus Crash levels, and investors have made money.
So while crashes are scary and make it seem like you should sell all of your investments, that is the exact opposite of what you should do when we enter a bear market. When prices fall, the value of your investments goes down on paper, but you don’t actually lose money until you cash out your investments at a loss. This is the difference between taking a paper loss (you see the price is lower), and a real loss (selling your investments at a lower price). Unless you absolutely need to use the money you have invested to pay your bills right now, you should ride out the bear market, because as history has shown, the market will rebound. A bull market awaits you just over the horizon and you stand to make even more money if you can be patient.
And that brings up another point about your investments. They can provide additional passive income during tough times. If you invest in a diversified portfolio of stocks, like the S&P 500, a portion of these stocks probably pay dividends. A dividend is a share of a company’s profits that it pays out to its shareholders. When you’re trying to grow your wealth, you usually reinvest all of your dividend payments, but if you find yourself in a financial bind, you can skip reinvesting your dividend payments and instead use them as a passive income source to cover some of your expenses during a tough time. Again, this only works if you remain invested through the lows of the recession, so try to avoid selling your investments in a bear market if possible.
3. Keep Investing When You Get Scared
Market crashes aren’t great for the money you already have invested, but they are fabulous opportunities to make more.
When prices drop and the market crashes, stocks are essentially on sale. It’s like if you bought a dress for $100 full price, and the next day it gets marked down to 50% off. Same dress, half the price. Buying a diversified set of investments like the S&P 500 index when prices drop is basically like getting them at a bargain rate.
Let’s assume you were an investor in 2008. If you had continued investing through the 2008 recession, you would’ve made a lot more money than if you’d gotten cold feet and stopped investing. Before the market crash, S&P 500 shares were trading for around $1,500/share. At their lowest point, these same shares were trading for less than half that price at around $700/share. If you continued investing through the recession and purchased shares at their lowest price, your investments today are worth 5X more than they were when you bought them in 2008! In comparison, all of the shares you had purchased before the 2008 recession have only increased in value by 2.3Xs. While doubling your money is great, quintupling it is even better. By continuing to invest through a recession you can offset your losses on the money you already have invested and make huge gains.
Since recessions affect different companies in different ways, this strategy only works when you invest in diversified instruments like index funds or ETFs. Some companies are bound to fail during the recession, so hand-selecting companies to invest in increases the likelihood that you’ll lose a significant amount of money if one of them goes under. To avoid this, stick to investing in index funds and ETFs during a recession unless you’re willing to lose everything.
The easiest way to stick out your investing strategy through a downturn is to use a method called dollar-cost averaging. This is just a fancy way of saying ‘invest at regular intervals’. The first benefit of using this method is that you’ll be able to buy when prices drop because you’re consistently investing. The second advantage is that you can automate your contributions so you never have to think about making them. Making more money without having to lift a finger sounds like a huge win to me. Whatever type of investment account you’re currently using, it’s a good idea to automate your contributions now because you’ll be more reluctant to do it during the next recession when the market is volatile or you’re struggling financially.
Since many people only invest through their 401K, if you lose your job and therefore your 401K contributions, you’ll need to take some extra steps to keep investing. Opening a Roth IRA is a great option because all of your contributions grow tax-free forever. If you lose your job and have enough financial stability to keep investing, open a Roth IRA and begin making automatic contributions to that.
By taking these 3 steps, you can create a financial plan that will significantly minimize the effect the next recession will have on your finances and avoid losing all of your money. Your emergency savings can save you from financial devastation if you lose your job, your investments can offer a source of passive income, and if you’re able to continue investing you can make significantly higher returns. Taking these steps to create a financial plan for a recession will not only allow you to coast through the next one, but will also help you come out ahead in the long run. Trust me, your future self is going to thank you.