There’s been a lot of talk about recessions lately. Mostly pundits have been warning us that a recession is on the horizon. Recession is a word that appears to strike fear in the hearts of ordinary investors and while it’s easy to understand why, that’s entirely the opposite of the reaction they should have.
A recession certainly can be painful if it results in a job loss, but for the longer term, it can be healthy for the overall economy. The media has positioned recessions as the monster in the basement, woods or under the bed (whichever you find most frightening). Instead of being an aberration, the business cycle, which reflects the expansion and contraction of the economy, is as natural as the seasons. Business cycles have four phases: expansions, peaks, contractions and troughs.
- An economic expansion is characterized by positive gross domestic product (GDP) growth, low unemployment, a bull market and consumer confidence.
- A business cycle peak is the transition from the end of the expansion to the contraction.
- During a contraction, consumer demand slows, the economy weakens, unemployment increases and stock prices usually decline. A recession occurs when GDP growth has been negative for two successive quarters.
- A trough represents the transition from the contraction phase to the expansion phase.
The Business Cycle
The brown line represents a demarcation for entering a recession (two consecutive quarters of negative GDP).
Despite all of the noise, recessions are actually beneficial because they provide relief for an economy that has overheated, and they are typically caused by or result in two positive changes in behavior:
- First, consumers who have cut back on their spending and are reevaluating their finances are often cited as the cause of a recession, and
- Second, during recessions, companies make a concerted effort to better manage their assets and their workforce.
Instead of panicking at the thought of a recession, investors would be much better off understanding and accepting the inevitability of recessions, planning for their eventuality and welcoming the expansion that will follow.
Of those activities, planning is the most critical because recessions often force investors to “tighten their belts.” One of the best ways to prepare is to establish an emergency fund. While the desired amount of an emergency fund varies, most experts recommend setting aside an amount equal to six to nine months of expenses in an investment that doesn’t fluctuate dramatically in price like a money market or a low duration bond fund.