What is a recession & how to financially prepare for it

A recession is a period of economic contraction. Though not as bad as depressions, they can affect incomes and prices and are typically accompanied by market downturns. It's natural to feel uneasy when there's an increased risk of a recession on the horizon. But the good news is you can protect yourself by preparing in advance with a few simple strategies.

A recession is a significant and sustained period of declining economic activity, often characterized by a drop in output, measured as Gross Domestic Product (GDP), for at least two consecutive quarters. However, the National Bureau of Economic Research takes a holistic approach determining when a recession occurs by considering various economic indicators beyond GDP. Economic downturns can impact financial planning and require proactive measures to safeguard personal finances.

Many factors can indicate a recession may be approaching or that one is already in motion. Consumer confidence tends to crash before a recession, driven by factors like declining house prices, increased unemployment and rising inflation. These things weaken consumer wealth, reduce purchasing power and create uncertainty about the future. Other factors, such as anxiety about a possible recession, tariff uncertainty and trade policies, also may significantly impact consumer sentiment.

The most common economic indicators of a recession are:

• Inflation: During peak business cycles, the economy is at maximum employment and producing at its full potential. In this situation, income can rise faster than increases in output, creating inflationary pressure. The Federal Reserve often will reduce the money supply to slow down the economy and curb inflation. While deliberate, this sometimes can lead to a recession. During a recession, inflation tends to level off, and prices even may fall.
• Gross domestic product: The hallmark of a recession is a reduction in economic activity. GDP is an aggregate measure of the economy, so if GDP growth slows, this may indicate the possibility of a recession. If GDP falls, a recession already may be in motion.
• Unemployment: Rising unemployment is a sign of recession. During a recession, spending typically falls, which means businesses don't need to provide the same level of goods and services. More people may be out of work as businesses cut back to reduce labor costs.

The difference between a recession and a depression is the level of severity. Recessions are not as deep, severe or prolonged as depressions and are a normal part of the ebb and flow of the economy. The conditions that cause recessions often subside before depressions build.

For example, the Great Depression began in 1929 and lasted for more than a decade. During this time, GDP fell by 29% and unemployment climbed to 25%. Recessions are less severe and normally last for no more than a few years, such as the Great Recession, which lasted for about 18 months (2007–2009), during which time GDP fell by 4.3%.

Preparing for a recession involves organizing your personal finances and minimizing risk exposure. Key strategies include increasing your savings, paying off debts and taking advantage of potentially lower interest rates to refinance high-interest loans. Building a robust emergency fund and revisiting your budget are essential steps to ensure financial stability during economic downturns. Effective financial planning and debt management are crucial to navigate these challenging times.

Although duration varies widely, the average recession since World War II has lasted for about 10 months. If you normally keep six to nine months' worth of expenses in an easily accessible account, consider bumping up this emergency fund to cover a few more months to ensure you're covered as long as a potential recession may last.

This is a good time to review your budget if you haven't done that in a while. To reduce overreliance on your savings, prioritize your expenses and aim to condense your spending to the most essential products and services.

Debts can be a source of strain when money gets tight because they often have fixed monthly payments. This puts your finances at risk if you experience a drop in income. Try to chip away at debt payments regularly so you aren't financially strained in the event of a recession.

Securing your short-term finances with an adequate emergency fund, sound budget and minimal debt also protects your future. It allows you to keep saving—or at least not raid your retirement accounts. This is important because consistency is the key to taking full advantage of compound interest and achieving your long-term goals.

A financial advisor can help you protect your assets by ensuring your investing strategy remains aligned with current economic realities and your long-term goals—including your risk tolerance.

During recessions, markets typically experience declines as investors withdraw due to fear of losses. To avoid discovering that your investments were overly aggressive after a downturn, it's important to evaluate your risk tolerance, time frame and investment strategy in advance. Diversifying your portfolio and including defensive stocks and bonds can help mitigate risks. Understanding market volatility and maintaining a balanced portfolio are key to protecting your investments.

First, evaluate your risk tolerance and investment time frame to ensure that your portfolio is appropriately balanced at your comfort level. This means allocating assets that match your risk tolerance with the right mix of stocks and bonds.

Next, ensure your portfolio is broadly diversified to help reduce risk. You also may want to include some specific investments that tend to fare better in market downturns, such as:

• Defensive sector stocks. This includes things like utilities and health care, which are often more stable because they provide essential services, and consumers generally continue to buy them even during economic slowdowns.
• Bonds. These provide a stable cash flow stream, and their value even may rise during a recession. Bond values are inversely related to interest rates, so when the Fed cuts rates to boost the economy, their price rises. This can offset some of the losses you may experience in equities.

Recessions can spark fear and uncertainty, and it's normal for investors to feel anxious. But creating an investment plan that's aligned with your long-term goals can help keep you focused and may dissuade you from making rash or emotionally charged decisions. Consistently contributing to your savings and investments allows you to benefit from compound interest over time, even during periods of market volatility.

Investors who pull out of the market out of fear may remain on the sidelines too long and miss out on exciting opportunities when markets turn around. For example, you could miss the best days of a market rebound by not sticking with your long-term investment plan. If you're regularly contributing to a savings account, market declines can present an excellent buying opportunity when stocks are cheaper.

The best way to protect yourself from a recession is to prepare in advance. If you can create and stick to a budget, contribute to a savings or emergency fund, consistently pay off debt and seek the advice of a financial advisor to protect your investments, you're more likely to stay the course—and weather the storm—when an economic downturn hits. Effective financial planning and debt management are essential to maintaining financial stability.

Contact a Thrivent financial advisor to discuss your plan and make adjustments now to put yourself in the best position.