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How to financially prepare for a recession

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Maskot/Getty Images/Maskot

As you carefully manage finances for your household, media talk of a recession likely catches your attention. After all, any uncertainty in the market can unsettle the financial footholds you've been working so hard to gain.

But knowing how to prepare for a recession can empower you to handle the potential setbacks. You can start by focusing on constructive action, not letting your emotions get the best of you and sticking to your long-term planning goals.

Is a recession coming?

The National Bureau of Economic Research defines a recession as "a significant decline in economic activity that is spread across the economy and that lasts more than a few months." But when many people think of a recession, they think of the Great Recession of 2007-2009. It's important to distinguish what's happening now from that event, when the banking sector, housing market and overall economic climate were quite different.

Economists differ on the odds of the U.S. heading into a recession in the 2020s. They're keeping an eye on risk factors like high interest rates and a handful of outlying banks that failed in an otherwise well-capitalized system with protections like FDIC and SIPC insurance. Even if a recession does emerge, some experts predict it would be mild. Whether a recession comes sooner or later, there are steps you can take to shelter your financial strategy.

Review your investment risk tolerance

Risk is a fundamental element of investing as there's always a possibility that things won't go your way. Your investments could lose value, inflation could dent your returns or you could outlive your savings. People also have different risk profiles: Some are willing to endure losses because they expect high returns in the long term. On the other hand, some people may sleep better owning assets that consistently produce lower returns but are considered to be safer investments.

During uncertain economic times, you'll likely see some disappointing stock returns if the market enters bear territory. At this stage, you'd see stocks drop in value, and the wider sentiment around the market would turn more pessimistic. Bear markets can put your particular risk level to the test, so you'll want to feel secure in your choices.

If you're unsure about what to do with your money in a recession, set up a meeting with a financial advisor. They can help you navigate the unknowns and understand how your investments are likely to perform if there were a downturn. Plus, if market volatility causes your original allocations of stocks, bonds and cash to shift in a way that no longer matches your risk tolerance and objectives, your financial advisor can help you rebalance your portfolio.

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Remember money & emotions don't mix

It's understandable to feel influenced by the negative feelings around the economy snowballing in the media. These emotions can tempt you to stray from the long-term financial plans you've built for your retirement savings and keep you from achieving other goals. If the next step feels like you should stop investing and hoard your money, take a moment to gain perspective. Discipline in investing, while certainly challenging, is key during a recession. Now more than ever, try to stick with your big-picture financial strategy and proactive investing.

Recessions typically last around 10 months, and the largest market gains often follow the largest declines. Consider that before 2022, the stock market had endured 13 bear markets since the end of World War II, as measured by the S&P 500 Index. It fully recovered each time in an average of 26 months, with the index exceeding its peak by an average of 68%.

Diversify your assets

It may be time, however, to adjust your holdings. It's a smart tactic to have your portfolio include a diversified mix of assets to help you minimize losses. For instance, you may want to include some investments that tend to perform better than others in recessions, like stocks in the healthcare, utilities and staple consumer sectors. Generally, equities tend to stand the test of time—the stock market has historically garnered average yearly returns of roughly 10%.

Leverage dollar-cost averaging

You can also consider the dollar-cost averaging concept, which is when you invest a fixed amount of money over a fixed amount of time rather than trying to time the market. You may even be able to set up an automatic investment plan so you can more easily set your strategy for the long run. This tactic can help to take some of the emotions out of your investing and potentially help you build a more diversified portfolio over time.

Amp up your savings & revisit your budget

Another way to financially prepare for a recession is to start putting money into an emergency savings account if you haven't already. This financial cushion could be a lifeline if something unexpected happens, like a job loss. Having a separate emergency fund could keep you from having to dip into your main savings, increase your debt or pull back on your investments. An ideal goal is to stash away about six months of income that you can easily access in an account that can offer some interest growth. Savings accounts, money market mutual funds and certificates of deposit are some options.

To help divert money to your emergency account, take a close look at your budget. (If you don't have one yet, you can check out tips for building a budget.) Once you have a good picture of where your money goes, look for no-value-added expenses, like subscriptions or memberships you don't use anymore. Then move that freed-up money into savings.

You can look at other categories for cutting, too. If you see you're dining out more than you'd like, for instance, make a goal to cook at home or bring your own lunches. Or if your phone bill seems too high, challenge yourself to find a better deal with another carrier. When you go to review your budget each month, celebrate your progress as you watch your small changes add up.

Analyze & minimize your debt

Sometimes, taking on debt helps you reach important family goals, like buying a home or paying for college. Those things could be considered "good debt." But "bad debt"—where you're overextended on purchases that don't hold any increased future value—can inhibit you from spending, saving and giving according to your values. This burden can become weighty if money becomes tight during a looming recession.

Use your budget to keep track of your obligations and devise strategies for paying down debt. If you have a lot, attacking it all at the same time can feel overwhelming. A common effective strategy is to prioritize paying off high-interest debt first. Keep making at least the minimum payments on your other debts to stave off interest and fee accumulation, but put extra toward ones with hefty rates, like credit cards. Setting a schedule for when you want to pay off each debt can help you stay focused.

It also helps to be aware of your  debt-to-income (DTI) ratio, which shows how much of your income goes toward paying debt. You can calculate this by dividing your total monthly financial obligations by your pre-tax, gross monthly income. A DTI ratio of 35% or lower signals that your debt level is probably manageable. If it's above 45%, it suggests you may not be able to cover unexpected expenses and that your financial stability may be at risk.

Find a reliable financial partner

With all the uncertainties a recession can usher in, you want to feel secure in the financial company that's handling your investments and assets. To ensure you're working with the right partner, review the publicly available information about a prospective company's financial strength ratings, performance in recent years and capital reserves. You may also want to explore their investment philosophy and values to determine if they sync with your own.

Taking time to consider what to do before a recession can give you confidence to handle what's ahead, no matter the curveballs that may or may not come. A local Thrivent financial advisor can help you devise a plan of action that's tailored to your life and helps you achieve your financial and big-picture priorities.

While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.

Dollar-cost averaging does not ensure a profit nor does it protect against losses in a declining market. Because dollar cost averaging involves continuous investing, investors should consider their long-term ability to continue to make purchases through periods of low price levels and varying economic periods.