Recession 101: Everything You Need to Know

Jan. 23, 2008 — -- The U.S. economy's slowdown and the Federal Reserve's cut of the interest rate Tuesday have more people thinking and talking about a recession.

In a recession there are certain things you can do to protect your assets and plan for the future. "Good Morning America" financial contributor Mellody Hobson and Stephen Dubner, co-author of the best-selling book "Freakonomics," give you a quick course in knowing and understanding recessions and what they mean to you.

What is a recession?
A recession in the simplest terms is two consecutive quarters of the U.S. economy slowing down, Hobson said. Now here's the thing about a recession, you don't know you're in one until you're actually in it. There's no way to predict it, she added.

Everything about a recession is backward looking. Right now all of the signs are there. The U.S. economy is definitely slowing down. That housing bubble has burst. There's no question about it. The U.S. consumer is feeling pinched, Hobson said.

How bad will the potential recession be?
In terms of how bad it is, it may be bad, but I think it pays to think of it in being in a long marriage, Dubner said.

Think of it as a marriage. You've been married to someone for 30 years. You have a big knockdown, drag-out fight. That doesn't mean you'll kill your husband or anything like that. You've gone a downward bit and shouldn't ignore the fact you have 30 years and probably some more good years ahead.

What is the difference between a recession and a depression?
Some people are using these terms interchangeable and they are not synonyms, Hobson said.

We've had only one depression and since World War II, we've had 10 recessions. A depression is huge and that's when you're talking shanty. We're not close to something like that, she added.

Recessions are part of the economic cycle, Hobson said. The longest one over the past 60 years was about 15 months. We would probably not even see anything like that today. Even though the United States is a driver of the world economy, we now have some major buffers like China and India that are also growing very fast.

People should diversify their funds, Hobson said. That's why I like mutual funds for 401(k) plans. Make sure you buy funds that are domestic and international. Also, make sure you're buying mutual funds that are value funds.

When you have all of that diversification, ride out the tough periods but don't sell right now, she added.

What lessons can be learned from this slowdown?
The great lesson to be learned from what's going on right now is that people shouldn't buy what they can't afford, which Americans are very good at, Dubner said.

It will come back to get you, he added. For example, you might see a $200 jacket you want, don't have the money for it. You charge it to your credit card and make the minimum payments. By the time you're done, that jacket costs $600 without you knowing it.

Compound interest is the eighth wonder in the world. It works for you if you're an investor, but works against you if you're paying for things you shouldn't be buying, Dubner said.