History Repeats Itself: How To Prepare for a Recession

The U.S. economy is robust and diverse, but when growth rates fall into the red and unemployment rises, a recession can emerge. The U.S. has experienced two recessions in the last 15 years: the Great Financial Recession of 2007-2009 and the pandemic-induced recession of 2020.

Since early 2022, fears of another recession have grabbed financial headlines, largely due to record-high inflationary pressure and the Federal Reserve’s focus on reducing inflation by raising interest rates. Inflation has moderated in 2023, but economic anxiety remains elevated.

Regardless of how you feel about the state of the economy, there are some things you can do to improve your finances and protect your investments.

How To Prepare for a Recession

Conducting worst-case scenario planning for economic crises and implementing appropriate measures is the most holistic and effective approach to protect yourself from a recession. This entails ensuring you have a solid budget, ample liquidity, minimal debt, a diversified portfolio and appropriate investments in yourself. These are all things designed to ensure you have access to money you may, but probably will not, need. 

This may seem unnecessary to individuals inclined to lean hard into risk-laden ventures. Nevertheless, it is invaluable when the economy goes off the rails, which it inevitably does, and at an increasingly frequent clip.

Buckle Down Your Budget

A sound financial plan always begins with an assessment of your current financial state, the establishment of a sensible budget and an estimate of short- and long-term objectives. The starting point is determining the amount of income you bring home each month and the extent of your essential spending, which is formally referred to as nondiscretionary spending.

A recession can throw the best of plans awry, especially if it involves a job loss. Having emergency savings of about six months of expenses can cushion the financial hardship and keep you on course for your retirement savings. One option for investors is to use their Roth individual retirement account as both a retirement account and a source of emergency savings (but only if absolutely necessary). Roth contributions (but not earnings) can be withdrawn tax-free and without penalty at any time.

Toby Walters, CFA®Senior Financial Analyst

Toby Walters, CFA®, is a senior financial analyst with over 25 years of experience in financial research. His knowledge spans researching and analyzing financial data to developing a one-of-a-kind viewpoint on money-related topics.

Income Considerations

When you look at your income, consider how much you take home each paycheck after accounting for income taxes and key deductions, such as health care premiums and 401(k) contributions. Then, spend some time thinking about how you can increase your income via freelance gigs or passive income streams.

Be realistic when brainstorming your options, but strive to be as creative as possible. The importance of this exercise cannot be understated. If you lose your primary income in a recession, a backup source of income is invaluable.

Spending Considerations

Essential spending is a largely inflexible part of your budget. It represents needs rather than wants, and it encompasses an array of important categories, such as rent, utilities, groceries and transportation.

Nonessential spending is the opposite. It consists of discretionary categories, such as vacations, dining out and streaming memberships. You can live without these items, and if times get tough, cutting them can improve your budgetary position. 

For the best results, take cutback action in advance of the next recession. You don’t have to eliminate everything discretionary, but rationalizing where you spend your money can yield real savings. It can significantly enhance the control you maintain over your day-to-day spend without sacrificing quality of life.

Looking Ahead

After ensuring you have clear visibility into your income and nondiscretionary versus discretionary spend, it is critical to forecast significant financial obligations. Take special care to document expenses you anticipate within the next five years. This could include a wedding, a down payment for a home, a school tuition or an imminent retirement.

Boost Your Emergency Savings

Financial experts recommend having six to nine months’ worth of nondiscretionary spend in savings in case of an emergency. Maintaining six to nine months’ worth of income, including both nondiscretionary and discretionary spend, is an alternate, more conservative guideline. Regardless of the size of your liquidity reserve, the funds should be highly accessible at all times. 

Recommended savings vehicles are high-yield savings accounts and stable-value money market accounts. When evaluating your options, compare the interest rates offered. The higher the rate, the more passive income you can generate.

Terry Turner, senior writer and financial wellness expert for Annuity.org, advises that six to nine months of savings is enough to find a new job, even in a recession. “An emergency fund lets you pay your bills and day-to-day expenses without using credit cards or damaging your credit rating,” he says.

If you don’t already have emergency savings, start saving as much as you can without compromising your retirement goals. An emergency account can keep you afloat if you lose a job, and it can also cover surprise expenses like car repairs.

Reduce Your Debt

Reducing debt is another key measure to take to prepare for a recessionary environment. When times are good, taking on debt for a new car, entertainment center or furniture set is fine. However, monthly payments add up, and in times of economic stress, you want as manageable of a burden as possible.

In addition to providing peace of mind, reducing debt can save you hundreds of dollars a month. Additionally, a lower debt-to-income ratio will expand your credit opportunities, giving you greater financial flexibility in the event of an emergency. 

Diversify Investments

Maintaining a diversified portfolio is a fundamental strategy to protect your investments from economic downturns and losses. Generally, this means holding a mix of fund-style, investment-grade bonds, stocks and alternative investments. The ideal allocation depends on your investment objectives and risk tolerance, two multifaceted and interrelated drivers that are most effectively assessed with the help of a trusted financial advisor.

Most people strive to achieve some combination of capital preservation, income generation and wealth accumulation. That said, each asset class has a unique risk-return profile, accentuating certain objectives. Again, a financial advisor can help you understand these differences.

Generally, higher returns are associated with higher levels of risk, while lower returns are associated with lower levels of risk. The objective of diversification is to combine assets from different categories to smooth out return patterns and facilitate better investment results in the long run.

Historically Defensive Stock Sector

Health Care

Health care spending increased 9.7% to account for 19.7% of GDP in 2020.
Examples: Pfizer | UnitedHealth Group | Johnson & Johnson

Consumer Staples

Demand for food and household goods remains stable or even increases during recessions.
Examples: Procter & Gamble | General Mills | Kroger

Utilities

Utility stocks are heavily regulated and traditionally perform well during economic declines.
Examples: American Water Works | AES Corporation | NextEra Energy

Budget Retailers

Walmart shares increased 12% during the Great Financial Recession and 10% in the first half of 2020 as demand for affordable, nondiscretionary household goods increased.
Examples: Walmart | Costco | Dollar General

“It’s actually a good idea to talk to your financial advisor before a recession,” recommends Turner. “If you’re worried about the economy, a licensed professional can help you understand what’s going on and counsel you on your particular financial options.”

Learn how to diversify your portfolio and protect your family’s peace of mind before the risk of recession hits.

Plan for the Long-Term

Generally, your investments are most lucrative when left untouched. This is especially true during recessions when panic-induced selling can cause you to incur an unrecoverable loss of wealth. The cool-headed move is to stay invested and give the market time to rebound. Doing so will enable you to keep your savings on an upward trajectory over the long term.

As you enter a recession, Turner reminds you to stay calm and consult an expert. “Before you start moving your investments around, talk to your financial advisor,” he says. “Different investments — stocks, bonds, mutual funds — can behave differently in a recession. A professional advisor can guide you through the best steps to take for your particular situation.”

Invest in Yourself

Building your career and reputation is another way to defend against a recession. Investing in yourself builds job security and minimizes the possibility of losing your key income stream during an economic downturn. Whether you love your career or are interested in a change, the following list outlines several ways you can improve your situation:

• Go back to school to advance your career prospects.
• Study to enter a defensive field, like health care.
• Build your personal brand and expertise.
• Expand your skills and income streams through freelance work.
• Learn more about the economy and personal finance to make confident money decisions.

Frequently Asked Questions About Preparing for a Recession

Editor Bianca Dagostino contributed to this article.