Soaring inflation, raising interest rates, and generally negative consumer sentiment have together cast a pall on today’s economic landscape. As a long-term investor, there isn’t much you can do to change any of the broad market indicators, but there are a few things you can do to manage through them — especially in the event of a recession.
Let’s briefly take a look at four ways to prepare for a potential contraction in economic activity.
1. Secure your emergency fund
You’ll rarely ever regret having more cash on hand than you need, so be sure you’ve stashed away at least six months of living expenses in an easily accessible — and fully liquid — savings account. You can easily compare rates across providers to determine which gives you the best deal, though the key aspect of the emergency fund is that it’s insulated from market volatility and can be accessed quickly.
There is a temptation to think you can get away with investing your emergency fund in certain securities like dividend-paying stocks or bond mutual funds, but this is really not recommended. As we’ve seen, markets can and do drop fast, so you’ll need to be sure that you’re squarely on the sidelines with your emergency fund.
2. Keep earning money
This may seem obvious, but it’s best to avoid withdrawing large amounts from your portfolio during a recession. When stock values have declined, selling shares to cover everyday living expenses can meaningfully eat into your portfolio’s long-term growth potential.
If you’re in your early career, try to make yourself indispensable at your current company, and think about alternative income streams if necessary. Even though it’s usually an option, taking a 401(k) or other retirement plan loan to cover expenses can jeopardize your long-run savings goals.
If you’re a pre-retiree or in retirement, any extra income goes a very long way in the effort to maintain your savings. While there are certainly pros and cons to working in retirement, having earned income can help you limit portfolio withdrawals and also provide nonfinancial benefits.
3. Keep investing
While it’s emotionally counterintuitive, when the markets are in turmoil is actually the best time to buy in. Every dollar you invest — whether it’s in a 401(k) or a regular taxable account — buys more shares than when the market was at its peak. When the market finally recovers, you’ll have more than you started with (assuming no withdrawals in between).
Shutting off portfolio investment after prices have dropped is undoubtedly a way to limit your potential for wealth creation. Picking a fixed interval and investing periodically (e.g., once a week, once every two weeks) is a prudent strategy when it comes to financial planning — regardless of what’s happening in the stock market.
4. Consider Roth conversions
Roth conversions involve moving money from pre-tax IRAs, like traditional IRAs, to Roth IRAs, which allow for permanent tax-exempt growth. When the market experiences a decline, Roth conversions become comparatively cheap; in other words, there’s a lower tax cost to converting when market values have fallen.
Roth conversions — even though they’re cheaper during downturns — will still add to your taxable income for the year and increase your tax bill. If you’re experiencing an income decline or if you’ve recently retired, additional Roth conversions might make sense now more than ever. You may also want to consult with an experienced tax advisor if you’re having difficulty deciding on a strategy.
Control what you can
Falling markets aren’t fun for pretty much any retail investors. But there are some things you can do to make life a little easier in the long run, especially if we do experience a protracted downturn. You’ll want to have your emergency fund secure, to keep working, to keep investing, and, for more advanced planning, to consider converting money to Roth IRAs.
We can only control so much when it comes to investing, so make sure you’re doing everything you can when it comes to protecting yourself and your investment portfolio.
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