The classic definition of a recession is when the nation suffers two consecutive quarters of declining gross domestic product. But to non-economists, recession means higher unemployment, lower interest rates and hard times — particularly if you're retired or nearing retirement.
You can guard against the worst effects of recession, though, if you follow a few simple steps.
Consider these five strategies: Build up some cash. Avoid the temptation of high-yield securities, such as junk bonds. Look for bargains in the stock market that pay solid dividends. If you're nearing retirement — or are semi-retired — prepare for the possibility of losing your job. And if you're really worried, spend some of your retirement money on a financial planner.
Cash isn't trash
In Wall Street parlance, "cash" is any investment that can be turned quickly and painlessly into spending money. Your money market account at a bank, for example, is considered cash. So is your money market mutual fund. Treasury bills and other short-term interest-bearing investments are considered cash, too.
Thanks to the Federal Reserve Board's recent series of interest-rate cuts, yields on cash investments are somewhere between very low and minuscule. A three-month Treasury bill yields a scant 2.2%. The average money market fund yields more — 3.4% — but such yields will be falling in the next few weeks as the funds replace their older, higher-yielding investments with new, lower-yielding ones.
Still, cash remains one of your best investments in a recession. Why?
•Safety. A 2% yield looks pretty good compared with, say, a 10% loss in the stock market.
•Liquidity. Your biggest risk in a recession is the loss of your job, if you're still employed or semi-employed. If you need to tap your savings for living expenses, a cash account is your best bet. Stocks tend to suffer in a recession, and you don't want to have to sell stocks in a falling market.
How much of your portfolio should you have in cash? If you're still working, you want cash equal to about three months' worth of living expenses in a non-retirement account. (You'd pay tax and penalties if you took an early withdrawal from a retirement account before age 59½.)
But that's a very rough rule of thumb, says Louis Barajas, a financial planner in Santa Fe Springs, Calif. If you're in the financial-services industry, for example, you might want to keep six months' salary in cash, because it might take you awhile to find a new job. If you're a nurse, you can probably keep less in cash, Barajas says, because nurses are in high demand, even in a recession.
If you're retired, you should probably keep about a year's worth of living expenses in cash. The average bear market lasts 404 days, or a bit more than a year, according to Jeff Hirsch, president of the Hirsch Organization, which publishes the Stock Trader's Almanac. Taking withdrawals from your stock portfolio in a bear market will just exacerbate your losses.
Don't reach for yield
When the economy slows, the Federal Reserve tends to lower short-term interest rates to try to get business humming again. That's great if you're a borrower. It's rotten, though, if you live off your savings. But don't be tempted by high-yielding investments. At best, they're risky. At worst, they're a scam.
The 10-year Treasury yields 3.76%. That's how much you can earn without risk for a decade. It's not much.
You can get higher yields by accepting more risk. The question is: How much yield is enough? A 10-year, top-rated municipal bond yields 3.63%, according to Bloomberg. Municipal bonds are long-term IOUs issued by states, counties and municipal organizations, such as toll roads and airports.
That's an exceptional value, because interest from municipal bonds is free from federal and, sometimes, local taxes. If you're in the 25% federal tax bracket, you'd have to earn 4.87% before taxes to earn the equivalent of a 3.63% tax-free yield.
And the risk is low: Defaults are rare. Only about 0.3% of investment-grade munis default each year.
You can also score higher yields from high-risk junk bonds, which are issued by companies with shaky credit ratings.
Junk bonds now yield about 10%. But the chance that a junk bond will default is high — in which case you'd receive only pennies on the dollar.
Be wary, too, of con artists pitching high-yield investments such as "prime bank CDs." These are billed as CDs that only elite banks sell to each other. But they're just a way for scamsters to take your money.
If you're investing for retirement and can tolerate the risk of stocks over the long term, check out stocks with decent dividend yields. Dividends are vital. For one thing, they're a crucial part of overall stock market return. Over the past 30 years, the S&P 500-stock index has gained 1,445%. Had you reinvested all your dividends, though, you would have gained 3,751%.
Reinvesting your dividends over the long term is also a great way to build up a stream of income in retirement. Let's say you bought 100 shares of Consolidated Edison, an electric utility, 10 years ago. You would have paid $3,794. Ten years later, thanks to reinvested dividends, you'd have about 170 shares. Your total investment — including stock price appreciation — would be worth about $7,400.
Companies pay dividends based on how many shares you own. So having 70 more shares will have boosted your dividend payout. In the first year that you bought the stock, Con Ed paid $2.12 per share; you'd have received $212 in dividends. Had the dividend stayed the same and you had reinvested your dividends over the past 10 years, you would have earned $360 in dividends.
But Con Ed, like many companies, has raised its dividend regularly. It paid $2.34 last year, boosting your payout to $398 ($2.34 times 170 shares).
Companies that consistently raise their dividends give an investor an edge over bonds. A bond's interest rate doesn't change. And over time, inflation erodes the value of a bond's interest payouts. But a company that often raises dividends can help you whip inflation.
Plan for the worst
What's the worst that could happen in a recession? If you're nearing retirement, your biggest fear is probably losing your job. Not only would you lose income; you might also have to draw down your savings to make ends meet while you look for work.
Rising unemployment, unfortunately, is a hallmark of a recession. So it's best to take stock of your finances and see how well you'd fare if you were laid off.
You should view recession warnings as a kind of wake-up call to review your family's balance sheet.
"We become more cautious about how we spend," Barajas says. "We're more aware of impulse buying and ask ourselves if we really need something."
Rather than make big new purchases, it's better to pay down debts, particularly high-interest credit card debt. You'll increase your cash flow — and, if necessary, benefit from a larger credit line for emergencies.
Make a plan
Finally, develop a plan for your portfolio that suits your goals: retirement in five years, for example. Don't let the short-term terrors of the stock market scare you into making drastic moves, such as yanking all your money out of stocks and pouring it into cash.
"If you have a good asset allocation, you have bull and bear markets baked into the recipe," says Ray Ferrara, a Tampa-based financial planner. "One of the biggest mistakes is to move away from a discipline that has served you well."
A good asset allocation means that, from time to time, you'll have to rebalance, moving money from investments that have performed well into those that have done poorly. Barajas, for example, has shifted money into real estate funds, which have been clobbered over the past 12 months.
If you don't know how to make a financial plan, consider investing in one. You can find fee-only financial planners at www.napfa.org. And remember that recessions eventually pass. "We're going to have recessions and down markets," Ferrara says. "But there are going to be more good times than bad times."