Warren Buffett famously quipped, "You only find who is swimming naked when the tide goes out." He meant that it's easy to look good when everything around you is fine and dandy, but when things change for the worse, it becomes clear who has been faking it. An example -- people with large debt payments who scrape by when times are good but find themselves in financial straits after a job loss.
While things appear pretty swell in the economy and the broader market so far this year, December's stock market rout reminded investors how fragile the market can be. If the economy slows down or a recession occurs this year, it could spell big trouble for the stock market and even your career. It's a good idea to take the time now to prepare as if an economic slowdown is coming, so here are three ways to ensure you're swimming with a suit on, for when the tide eventually goes out.
1. Build a robust emergency fund
It's time-tested advice and something you've heard before, but while you're working, you should set a good chunk of money from your paychecks aside in a rainy day fund. There are some rules of thumb, like having three to six months worth of expenses in cash.
The amount you need varies depending on your job risk. For instance, a municipal employee with a guaranteed contract or a teacher in a union has greater job security and less need for an emergency fund than, say, a yacht salesman whose job is more directly tied to the economy. But the recent government shutdown demonstrated that no job is secure 100% of the time.
Having at least six months of living expenses in cash is a sound idea for anyone, regardless of job security. You may need to tap into your savings for any number of reasons including those big unexpected expenses that are inevitable for homeowners. Within two weeks of moving into my house, the water heater needed to be replaced and the dishwasher broke -- coming to a total of $3,500! People whose medical insurance plans carry deductibles as high as $5,000 or $10,000 need to be prepared to spend that amount out of pocket before insurance pays a dime.
An emergency fund can help. Start by setting aside a little each pay period and make it a habit, so every time you get paid, you transfer that amount into the emergency fund.
You might ask, "Where do you save your emergency fund?" The worst place is underneath the mattress or a hidden spot around the house where you'll forget it! Having that much cash around the house is a bad idea because it can get stolen, lost, or spent.
The best place to save money is in a savings account with a bank or you can create a separate checking account labeled "emergency fund" -- but don't touch it! A certificate of deposit (CD) is an option that may pay higher interest than a savings or checking account, but you get penalized if you need to tap the money sooner than the CD term, which can happen if you need the money in a pinch.
Another option may be saving in a money market mutual fund. If you have a brokerage account, you have access to a money market fund, which is like a holding account to save money while earning a higher interest rate than a checking account, and it's also more accessible than a CD. Money market accounts may not be insured by the Federal Deposit Insurance Corporation (FDIC) like a CD or checking account is, but they are widely considered safe investments.
Investing an emergency reserve in the stock market is not a good idea. If you need the money and the stock market is down, it may mean selling at a reduced price, and that's not ideal. You want your emergency fund to be in a safe and reliable place. Set a goal to get your emergency fund up to a reasonable amount -- at least six month's worth of expenses -- then start building your investment portfolio or saving in a retirement account.
2. Live like you didn't get a pay raise
While there are many things you can do with a pay raise, avoid increasing your spending. If you're nodding your head in agreement, you know how it happens. You sacrifice and put things off while you're young and underpaid, then as things get better and you advance in your career and get paid more, you accumulate more and want more things with each pay raise. It's a trap, though, and a cycle to be aware of.
While times are good now and money is coming in, try to keep the money from your next pay raise in savings, which can be for retirement or an emergency fund. You may want to increase your monthly contribution to your 401(k) which is easy to adjust. But the point is, don't create another expense, or worse, another fixed monthly expense that you're obligated to pay when and if you lose your job.
Besides saving extra money from your pay raise in an emergency fund or increasing your 401(k) contribution, increased funds from a pay raise should also go toward paying down any high-interest debt you have. Now is a great time to chip away at any outstanding variable-interest rate debt -- which is debt with a floating interest rate like a credit card or student loan that becomes more expensive when interest rates rise.
3. Diversify your investments
Don't wait to start diversifying your investments until you are jolted by a recession or market meltdown. By that time, your whole portfolio could be down sharply and any reallocation could come at a substantial loss.
To paraphrase economist Hyman Minsky, it's when we're most comfortable with risk that we're most susceptible. When times are good, we feel really good about our stocks -- maybe too good -- and we overlook the risk that they hold. (The risk is the amount that your stocks can go down.)
When the stock market dips, you'll see if you are truly well diversified. Now that the market has recovered somewhat from its December downfall, take the time to comb through your 401(k) or other investment accounts and ask yourself these three questions:
- Is my mix of stocks and bonds still appropriate for my age and time horizon for my retirement? A rule of thumb is to take your age and subtract that number from 110 -- this is a rough estimate of the percent of your portfolio that you should keep in stocks. A better way is to determine how much time you have until you'll need the money in retirement. Someone who's 15 years away from retirement may feel more comfortable investing more in stocks as they have more time to recover losses versus a retiree who will need to sell some investments this year to pay living expenses. That retiree doesn't have as much time to recoup their losses. The key is to make sure the amount you have in stocks aligns with your time horizon for needing the money. The longer your time horizon, the more of your money you may feel comfortable keeping in stocks.
- Is any one position accounting for more than 10% of my portfolio? Now is a good time to look through each position you own and see if it's too high relative to the overall portfolio. Having greater than 10% of your nest egg in one stock is a cause for concern in my opinion and you should evaluate the reason behind such a high concentration. This doesn't mean you have to sell the position, after all you may want to let your winning stock run even higher, but you should be aware of the exposure. An extreme example was when Enron collapsed in 2001 and workers who had large amounts of Enron stock in their 401(k) saw their retirement nest eggs get wiped out.
- Is there enough variety in my portfolio? Stocks and bonds are great but institutional money managers have far greater variety in the portfolios they manage. Other investments to consider beyond traditional domestic stocks or bonds includes real estate investment trusts (REITs), preferred stocks, gold, commodities, international bonds, and emerging market debt. Different asset classes may react differently to a U.S. recession and diversify the portfolio by spreading the risk around. This doesn't mean you go all in on any one of these alternative investments, but it's worth considering allocating between 1 to 5% of your overall portfolio in a different type of investment.
Pundits are always calling for a recession and even a broken clock is right twice a day. When the time comes that they are right, you'll be glad you followed these three steps to recession-proof your portfolio.
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