When I was in college, I had to take a handful of economics classes to earn my accounting degree. Those classes taught me a few lessons that I would otherwise have learned the hard way later in life. I want to pass on one of these lessons so you can prepare yourself and your finances for the inevitable.
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Economic Cycles Follow a Predictable Path
The economy follows the same cycle over and over again. Here’s how it works.
Let’s start during an economic boom or the peak of the current cycle. At some point, the boom will start slowing down for one reason or another. After all, nothing good lasts forever.
The slowdown will eventually turn into a recession or a depression. People will lose jobs, investment values will decline, and people will feel like they’ll never recover. Eventually, the economy hits the bottom of this particular cycle, called the trough.
Next, the economy starts to grow. People don’t realize it right away because things still seem bad, but growth will pick up, jobs will be created again, and investment values will rise. After some time, the next peak will be reached and the cycle will start all over again.
Essentially, the cycle starts at one peak and ends at the next one. It goes from a peak, to slowdown, to trough, to growth, to the next peak. Here is a chart illustrating this phenomenon:
While the picture shows a smooth and predictable path, it’s important to note the economy does not always have a smooth ride. There might be smaller peaks and troughs within a larger cycle. However, the concept of economic cycles remains the same.
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The Only Unpredictable Part Is How Long These Cycles Last
It’d be nice if the economy followed the smooth line in the image above and we knew exactly how long each cycle would last. However, if that happened, we’d all be rich beyond belief. Economic cycles vary in length and don’t follow the curve.
Economists, bankers, stock traders, and others will constantly try to predict when an economic cycle will start and end or when a particular part of a cycle will start and end. While they might be making educated guesses, no one knows when these periods start or stop. They just know they’ll eventually happen.
A TV pundit or analyst will eventually guess correctly because even a broken clock is right twice a day.
However, the chances that they’ll predict the next part of the economic cycle correctly are very small. That said, there are some signs that people look to in an effort to predict the next downturn.
“The inversion of the yield curve has almost always signaled looming recessions,” says Janene Tompkins, CFP and owner of Common Sense Financial Planning.
For those who don’t understand investment speak, longer-term loans typically cost more than shorter-term ones. However, when the yield curve becomes inverted, it costs more to borrow money over a shorter period than a longer period.
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How Economic Cycles Lure Average Americans to Make Bad Financial Decisions
Now that we know how economic cycles work, it’s pretty easy to see how Americans can be lured into making bad financial decisions during an economic cycle.
At the trough, people are panicking because they’ve lost their jobs or know someone who has. Eventually, things start getting better, but it doesn’t feel like it until after things have recovered a bit. Once people start getting comfortable again, they start seeing the economy grow and feel like things will continue getting better.
People might upgrade to bigger homes or newer cars. They might even buy a boat or RV, but they use a loan to make the purchase. Then, slowly but surely, things start turning south. It suddenly seems like those big purchases weren’t such a good idea.
Promotions and salaries get frozen. Next, people might start getting laid off. You might decide you want to sell that bigger home, newer car, boat, or RV, but your prospective buyers are dealing with an economic decline just like you.
If you lose your job, you could be forced to sell these things because you simply can’t make the payments anymore.
People who are prepared to take advantage of downturns get great deals from people who need to sell their new toys at a deep discount because they can’t make their loan payments. You could be the person ready to take advantage in the next downturn if you prepare now.
How to Prepare for the Next Recession Today
First off, make sure you’ve built a fully stocked emergency fund. Typically, that’s anywhere from three to eight months of expenses set aside in a savings account. Some financial institutions such as CIT Bank even offer high-yield accounts that give you a favorable interest rate on your savings.
With an emergency fund, if you end up unemployed, you can survive at least a few months without worrying about how to pay the bills.
Not worrying about money will allow you to aggressively search for your next job.
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When times are good, it never hurts to prepare an emergency budget, too. Look at your monthly expenses and see what fat you could trim if you suddenly lost your job or needed to cut your spending for another reason. You could easily cut back on dining out, or luxuries such as pedicures or lawn service, both of which you could do yourself for much less.
As the expansion continues, don’t lock yourself into debt for luxuries such as new cars, boats, or RVs. If you don’t have the cash already set aside for these things, a recession could hurt your ability to pay for them. Whatever you do, don’t count on a future promotion or raise before it actually happens. Rely only on the money available today.
Finally, if you know you want to make a big purchase, start saving for it today. Then, when the next economic slowdown happens, you’ll have the cash at hand to take advantage of the fire sale or discounted prices that might be available.
Take Advantage When Others Are Fearful
With your fully stocked emergency fund and savings plan in place, you’re headed in the right direction. However, there is one last thing you absolutely must not do during a recession: Allow other people’s fear to affect your investing decisions.
“Financial planning is the key. If you have your plan and your emergency fund in place, there is no need for you to change your investment strategy just because of the natural market cycle,” says Tompkins.
Generally, once the market starts heading down, people begin to worry about their investments. As investments continue going down, more people start freaking out and selling to try to make sure they don’t “lose all of their money.”
If you’re properly diversified, your investments could suffer a great decline in value during a downturn, but they shouldn’t all go to zero. However, if you own only stock in the company you work for, you could end up losing everything.
The key to growing wealth is to continue investing according to your diversified strategy even when markets go down. In fact, it’s more important to buy when investments go down because you’re purchasing them at a discount. If you get fearful and quit investing, you’ll miss out on the gains that will come during the next expansion.
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No One Has a Crystal Ball
No one knows when the next peak or trough, expansion or recession will happen. We only know that they will happen again at some point. Use your newfound knowledge of this economic cycle to prepare for what’s coming. That way, you can make optimal financial decisions when others are freaking out. You might even grow your wealth in the process.