The likelihood that the U.S. enters a recession has been growing as the Fed continues to fight inflation by raising interest rates. Recessions, significant periods of broad decline in economic activity, are inevitable, but still occur relatively infrequently (the U.S. has only experienced seven recessions in the last 50 years).

Compared to typical periods of economic expansion, recessions are also relatively brief, averaging roughly six months to two years in length. However, recessions can cripple household wealth and set investors back years from reaching their goals. Recessions are caused by unpredictable shocks or imbalances in the economy, but they occur often enough that they can viewed as a normal economic cycle worth planning for.

Shoring up finances

When preparing for a recession, households and investors should consider a time period of one to two years, during which asset prices may decline, job losses may grow, and borrowing may be more difficult. Once growth returns, then borrowing should become easier and asset prices should rise again.

Building and maintaining an emergency fund is a foundational element of personal finance, and it becomes more important in times of economic stress. Therefore, it should be the priority in recession planning. Reducing high interest debt is also important, and priority should be given to variable rate debt in the current environment, as rising rates will impact credit card minimum payments, as well as payments on variable rate mortgage rates and student loans.

Recessions also provide an opportunity to slim down our budgets. It may be easier to reduce monthly costs on discretionary spending if we keep in mind that recessions won’t last forever. Once the economy recovers, we can reinstate spending on items that we really missed, while those expenses we don’t miss can remain off our books for good.

Evaluating our likelihood for a job loss is important too. Small steps like updating resumes, building a new skill, or networking can provide some peace of mind. It also may be the ideal time to take action on larger steps we may be considering, such as developing a second income stream.

Investing in recessions

Ideally, as long-term investors, we are already prepared for market downturns through regular portfolio monitoring and balancing. We are well positioned for a recession if our investments have been allocated based on a thoughtful examination of our investment time horizon and risk tolerance, so that any dips in the markets do not discourage us. A well-prepared investor will already have an emergency fund in place, as well as investment cash to deploy strategically, prepared to bargain shop and capture value in a down market.

However, many investors aren’t prepared for a recession, despite the growing warning signs that a recession is on the horizon. After all, the last recession was only a few years ago, possibly leaving us less prepared for the next one.

Amid economic imbalances, seek balance

Investors who have not rebalanced portfolios within the last few years likely have too much exposure to riskier asset classes – the type of assets that fall in recessions – as those asset classes have outperformed recently. In this case, portfolios should be rebalanced to decrease risk and increase exposure to recession-resistant asset classes. But with the current levels of market volatility and unpredictable direction of economic indicators, investors should not overreact and dump investments or rebalance all at once. First, investors should determine whether rebalancing is even appropriate in the first place.

Revisiting target allocations across asset classes is advisable at least annually, and target allocations should be set before rebalancing begins. This generally starts by determining an appropriate allocation between equity, fixed income, real estate, commodities, and alternative investment classes. Within these broader asset classes, fine tuning portfolio investments to ensure palatable exposure to riskier assets – like high yield bonds or stocks that rely on economic expansion to fuel growth – can be helpful.

However, preparing for a recession does not mean hunting down and eliminating all risky assets in our portfolio. Remember that recessions are usually short-lived events. With an eye on the bigger picture, successful investors take gains from classes that have performed well and redeploy those profits to asset classes that have performed poorly. Recessions provide opportunities to capture value in depressed asset prices. To do so, we need to determine and maintain target exposures. It’s often too late to capture upside if we wait until a recovery is underway.

While rebalancing on an annual basis is generally acceptable, a plan to rebalance towards our target allocations on a quarterly basis is reasonable during times economic distress, or if allocations have been allowed to drift away from targets for some time. Don’t look to trade all at once.

Keep in mind that many mutual funds and managed financial products rebalance allocations on their own. Fund-of-fund products, like target-date funds, will rebalance regularly according to their objectives. Robo-advised products should automatically rebalance. In mutual funds with active management, many fund managers have already taken steps to prepare for a recession to the extent permitted within their investment mandates. Spending some time reviewing your funds’ investment objectives and the manager’s monthly or quarterly commentary (generally found on their website) can be useful to stay up to date regarding a fund’s preparation for recession.

Index funds, though, will maintain their constant exposure to the underlying index securities, so it’s important to keep a portfolio of index funds or ETFs well balanced.

If determining target allocations and rebalancing your portfolio becomes unwieldy (it does take time), then consider working with a financial advisor. A financial advisor can simplify the process and provide a professional perspective to help keep you on track.

How recessions end

Legislative efforts are often initiated to alleviate recessions and spur growth. When job losses increase and the GDP falls, political pressure forces lawmakers to act. Some of the largest bills enacted by Congress have been in response to recessions. However, recessions are usually resolved long before the effect of legislation kicks in and reaches its peak.

Rather, the economy generally recovers from a recession when the imbalance or economic shock that created the recession subsides. Along with natural economic correction, interest rate decreases by central banks can quickly spur growth, as lower interest rates encourage consumers to spend more on things like housing, vehicles, and encourage companies to borrow more to fund exposition. This, of course, can also lead to inflationary pressures, but central bank fiscal policy works more quickly than legislative efforts, and can be reversed more rapidly as well.

If the U.S. enters a recession, pay attention to the circumstances that precede the recession, such as inflation and rate tightening. Once the underlying causes of the recession normalize, the economy will likely begin to recover – hopefully with our financial health still intact.

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