The U.S. is officially in a recession. Gross domestic product declined 5% in the first quarter of 2020 and 32.9% in Q2, meeting the official definition of a recession, and the National Bureau of Economic Research confirmed that February marked its beginning.
If you’re lucky enough to have extra cash right now (let’s face it: many people aren’t) you might be wondering if it’s better to save as much as possible or take advantage of market downturns by investing.
Here’s a look at what you should do to protect yourself during this time of uncertainty.
How Much Should You Have Saved During A Recession?
As you might have guessed, saving money is never a bad idea. “Focusing on savings is typically one of the smartest money decisions a person can make, regardless of where we are in a market cycle,” said Lauren Anastasio, a certified financial planner at SoFi.
Keeping cash on hand in the form of an emergency fund is always recommended. Typically, you should aim to save three to six months’ worth of expenses. “I often recommend a three-month emergency fund for those who are renters, in dual-income households or have highly transferable skills that would make finding new employment easier if they lost their jobs,” Anastasio said. “Six months’ worth of essential expenses is more appropriate for homeowners, single-income households and anyone with children or other dependents.”
However, Anastasio said that as we enter a period of lower employment, it’s a good idea to have the largest financial cushion possible.
“While we will see unemployment rise, even those lucky enough to feel job security are not immune to recession-related cutbacks and their income can still be at risk,” Anastasio said. “You could find that scheduled pay increases stall, your bonuses could be cut back and overtime is harder to come by.”
If you are self-employed, have very niche skills or are retired, Anastasio said you may want to keep as much as 12 months’ worth of essential expenses in your emergency fund.
Banks and lenders also tend to tighten their lending standards during recessionary periods. That means loans and lines of credit, including credit cards, could be much harder to obtain. Keeping enough cash on hand not only helps you avoid accumulating debt in a financial emergency ― it could be your only option for covering expenses if credit isn’t available.
As for where to stash your cash, a high-yield savings account is usually the best option. Interest rates on savings accounts are pretty dismal these days, but the primary goals should be to keep your savings liquid, easily accessible and protected from risk.
Is Now A Good Time To Invest?
Once you have your emergency fund built up (and high-interest debts paid off), the next step is to put your extra cash into investments that can earn higher returns over the long run.
Depending on your personality, that idea could be panic-inducing. During the 2008 recession, the market lost approximately 40% on an annualized basis. Most recently, COVID-19 sent the market spiraling downward by more than 30% between February and March. “Looking at these numbers, there may be an urge to take your money and run,” said Mindy Yu, director of investments at Stash. “By taking a step back and looking at the market’s performance through the 2008 recession, through COVID-19, and up until today, you’ll notice it’s actually up more than 6% on an annualized basis.”
On the other hand, you might be excited by the prospect of trying to time the market or guess the next hot stock. However, research shows that individual investors are pretty bad at it. There’s no doubt that buying in while the market is down is a great way to increase your future returns. But investing is something you should do consistently and methodically, regardless of how the market is currently performing.
“The only thing predictable about the stock market is that it will go up and it will go down,” Yu said. “There’s no crystal ball to predict what exactly will happen in the future, so it can be critical that investors maintain diversification across their portfolios and accounts.”
One way to stick with a simple, disciplined investment strategy, according to Yu, is through dollar-cost averaging. This involves investing a set amount of money at regular intervals. For example, you might decide to invest $200 every month. This means you buy more shares when the market is down, and fewer shares when it’s up.
This allows you to participate in different share prices during the various investing cycles, ultimately coming out ahead. “By doing this, you can remove the emotional aspect of timing the market, and increase your time in the market, fueling growth potential through the power of compounding,” Yu explained.
In addition to dollar-cost averaging, there are a few other steps you can take to maximize your investments.
Keep an eye on diversification: You probably know not to put all your eggs in one basket, but diversification means much more than choosing more than one investment. It’s also important to diversify across investment types, such as stocks, index funds and bonds, as well as your portfolio concentration. For instance, Yu said there is a general tendency to gravitate toward U.S. companies. However, other regions perform differently in various economic cycles and economic crises, so it makes sense to consider those, too. “It’s important to not only be diversified in how you’re investing, but also where you’re investing,” she said.
Understand your goals and time horizon: Before you throw your money in the market, stop to consider why you’re investing in the first place. Are you saving for a home in the next five years, or for retirement decades from now? If you’re young and saving for long-term goals, your portfolio may contain a greater proportion of stocks. If you’re saving for a short-term purpose, you might want to choose lower-risk investments like bonds.
Review your portfolio and rebalance as needed: “Market movements with uncertainty can dramatically shift your portfolio allocation, subjecting you to risks that you might not have been aware of,” Yu said. Over time, your investments can become out of sync with your risk tolerance and goals, so it’s important to regularly review your portfolio and rebalance it as needed. “Rebalancing can put your asset allocation back in line by selling investments that have drifted overweight and buying those that are now underweight,” Yu explained.
Remember that it’s OK to start small: One of the biggest misconceptions about investing is that you have to have a lot of money to get started, Yu said. However, even the smallest investments can grow significantly over time thanks to the power of compounding. Regardless of how much money you have available to invest, the earlier you start, the more you have to gain.