Job insecurity, rising interest rates, and increases in the cost of living – at least one of these factors will have an effect on almost any investor. It’s easy to get discouraged, and even easier to make the wrong decision as a knee-jerk response to these difficulties.
Common mistakes such as panic selling, focusing on high-risk investments, and taking a bite out of your retirement savings can have a catastrophic effect on your finances – so avoiding them is of the utmost importance.
Here are seven crucial factors to keep in mind if you’re thinking of making any serious money moves when a recession is on the horizon.
1. Avoid Panic Selling
Panic is a natural human response to a recession – but natural does not always mean good, let alone optimal. Managing your emotional state when investing isn’t easy, but it should be one of your biggest priorities.
Panic selling is the first item on this list for a reason – panic, fear, and a rational, goal-oriented approach cannot exist at the same time – it’s one or the other. Panic selling leads investors to make choices that are rash and ill-thought-out – unsurprisingly, this leads to bad results.
Selling off your investments in the downturn frenzy means that your long-term goals will be compromised. A properly-diversified portfolio with large allocations in businesses that will survive a downturn will eventually bounce back.
Selling too early locks in losses that, in most cases, are temporary – not to mention that it prevents you from experiencing the growth that follows recessions. In fact, investing in a recession isn’t a mistake – you can purchase stocks at great discounts, so long as you identify companies that have real value and will survive the downturn.
2. Be Cautious with Credit
Although commonly touted as the ‘boogeyman’, credit has its proper place and purpose in your finances and investing approach – but recessions make everything in life more difficult, and credit is no different.
Taking on credit in a recession is always riskier than in normal circumstances. Economic downturns lead to a credit crunch, which means that the standards for lending become much more strict as creditors seek to minimize their own risk.
The danger of high interest rates and accumulating a lot of debt is simply much greater in a recession. It’s best to exercise caution here.
An ounce of prevention is worth a pound of cure – if you can avoid taking on new debt, then this risk becomes a moot point for you. This isn’t the case for the majority of Americans, however – so a more realistic goal is to try and limit new borrowing.
On top of that, focusing on paying existing debts and maintaining a good credit utilization ratio of under 30% are also priorities – but more on that later.
3. Avoid High-Risk Investments
While it is true that risk and reward go hand in hand when investing, there is a time for everything – and a recession is not a time to take on any more risk than you’re already facing.
Riskier investments like trading options might seem appealing at first, and, credit where credit is due, they do offer the potential for substantial and quick returns. However, investors often underestimate risk – and the significant losses that often come with these approaches shouldn’t be forgotten.
Recessionary environments cause these already volatile investments to experience even wilder price swings. This, coupled with the fact that recessions make everyone more risk-averse, is a perfect recipe for investors pulling out – leading to even further drops in price.
We’re not singling out options here – the same holds true for speculative stocks, penny stocks, cryptocurrencies, derivatives, startups, companies that are highly indebted, leveraged ETFs, and high-yield bonds.
4. Don’t Stop Investing Altogether
The markets always rebound, so staying invested is the only way to benefit from the inevitable recovery. Long-term growth opportunities require time in the market – and while the value of your portfolio might decline for a couple of years, continuing to invest remains – in many cases – the right call.
Of course, investors should take extra care to minimize risk. Several methods, such as dollar cost averaging, provide a way to both lower investment costs and increase returns while being simple to execute.
Staying invested also allows you to take advantage of compounding returns. Put simply, the concept boils down to this – staying invested leads to returns, and those returns can be reinvested to generate further profits.
If you don’t keep on investing, eventually, your portfolio’s asset allocation will drift away from what is ideal. This can easily lead to suboptimal returns and excessive risk – and the only way to fix it is by rebalancing, which entails selling and purchasing assets.
Although we cautioned against investing using options in the previous section, options can actually serve as another valuable risk-management tool in a recession.
Options allow investors to buy or sell securities at a predetermined price by a predetermined date. Call options give the right to buy, while put options give the right to sell an asset.
While we wouldn’t recommend using them as a primary generator of growth, we would recommend using them as a means of hedging. Hedging is a method by which investors reduce risk by entering a second position which is the opposite of their primary position. This helps to limit losses.
To use the most straightforward example, an investor going long on a stock would purchase a put option on the same stock. If the stock increases in price, the investor will have paid a small premium which slightly decreases returns. However, if the stock’s price were to suddenly drop, the put option would increase in value, reducing losses.
Options trading is a world of its own, and it can be difficult to get into – however, many options trading alert services leverage data-driven approaches to provide simple, beginner-friendly strategies. To make things even better, most of those approaches fall into the category of swing trading – no need to spend hours glued to a screen which is typically required when day trading.
5. Look for Alternative Income Sources Before Dipping into Retirement Savings
Although panic selling was the first point we mentioned in this article, that spot could have easily gone to dipping into your retirement savings. This is, by far, the costliest mistake you could make in a recession (or outside a recession, for that matter).
Going this route leads to several very detrimental effects. First and foremost, early withdrawals usually come with tax penalties – and having a larger tax burden in a recession should obviously be avoided.
On top of that, dipping into retirement savings strips you from years of growth potential – growth potential that is oftentimes tax-free or tax-advantaged.
The worst part of it all is that dipping into your retirement savings easily becomes habit forming – the instant relief of added money at your disposal is hard to contrast with future returns that seem abstract and very far away.
Instead of this, if you find yourself in a deficit with cash on hand, consider trying to tap into alternative sources of income. There are a wide variety of options here, so let’s make a list of some more common choices:
- Freelancing – taking on additional part-time work is the most profitable course of action – but how accessible this is depends on your area of expertise
- Renting out an extra room – If your residence has room to spare, consider renting it out either to long-term tenants or to a platform such as Airbnb
- Gig jobs – Side gigs such as food delivery, ridesharing apps or Uber, and house-sitting, pet-sitting, and babysitting can serve as a source of additional income
- Selling old items – Online commerce platforms or garage sales are a handy way to get some additional income while simultaneously decluttering your living space
- Tutoring – Giving private lessons and holding workshops in a subject that you have experience with is accessible and offers flexible working hours
6. Stay on Top of Debt Payments
Making consistent payments on your debt allows you to maintain a good credit score – leading to lower interest rates and making it easier to secure new loans at attractive terms in the future. On top of that, staying on top of your debt repayments helps you avoid unnecessary expenses such as late fees.
All of this contributes to keeping your overall debt under control – which goes a long way in reducing financial anxiety and allowing you to dedicate more money to other worthwhile goals – such as savings, investing, or an emergency fund.
Apart from keeping track of your expenses and sticking to a budget, there are three main approaches that we’d like to single out when it comes to managing debt:
- Debt Snowball method
- Debt Avalanche method
- Debt consolidation –
The snowball method works like this – list out all of your debts, starting from the smallest to the largest. Each month, pay the minimum amount on all debts – except the smallest debt, on which you will pay as much as you can.
Once the smallest debt is taken care of, the money that would have gone toward it is rolled over to the next smallest debt – and so on until you’ve paid everything off.
The debt avalanche method works by first paying off the debt with the highest interest rate. Once again, you pay a minimum on all of your debts, except the one with the highest interest rate – and then you work your way down.
Debt consolidation, on the other hand, works by combining all of your debts into one – usually with a more appealing interest rate. This can be achieved via a debt management plan (DMP), a debt consolidation loan, or via debt settlement.
7. Build an Emergency Fund
Recessions exacerbate financial risk – and no one is completely shielded from this. Losing a job, receiving a salary cut or fewer working hours, or even experiencing an unexpected expense – all of these factors are significantly more impactful in a recession.
Having an emergency fund in place provides you with a safety net that will help you weather any unexpected (and expected) difficulties.
Apart from helping you with worst-case scenarios such as job- oss and big, unexpected expenses, an emergency fund also helps reduce the stress and anxiety of a recession.
This measure of safety also allows you a bit more financial flexibility – for example, taking advantage of investment opportunities that might otherwise have been missed.
The conventional knowledge is that your emergency fund should cover between 3 and 6 months of total expenses. This fund should cover rent, mortgages, bills, insurance, transportation, gas, groceries, childcare, and any regular healthcare costs.
We don’t disagree with the conventional wisdom – but you should have 3 months covered even in the middle of an economic boom – for uncertain periods like the one we’re in right now, you should definitely aim for 6.
If your job is a competitive field and finding new employment is easy, you have some breathing room – but if you know that finding employment would take you more than 6 months, adjust the emergency fund accordingly.
Having a clear overview of all your expenses on a monthly basis is the first step toward building an emergency fund – but there are plenty of emergency fund calculators that can do the heavy lifting for you, giving you a very accurate estimate in just a couple of seconds.
Conclusion
Recessions are trying times, and no matter what you do, this will still be a tough, challenging period. However, avoiding the common pitfalls and mistakes that people make in these periods will go a long way in preserving and growing your wealth.
If you’re feeling discouraged, just remember that we’ve been here before, and there is always a light at the end of the tunnel – it’s just a question of staying on the right track.
This article was produced and syndicated by MediaFeed.
