How to Handle the Next Recession
Over the past ten years stocks have gone up more than 400%. The big question now, of course, is whether this rally will continue. While no one has a crystal ball, good financial planning prepares for these “what-if” scenarios and illustrates how to respond to them accordingly.
If you meet with a financial planner, they will most likely categorize your goals into two broad categories:
- “Essential” expenses: expenses you cannot live without
- “Discretionary” expenses: expenses that can be cut if necessary
The traditional approach is to include food, clothing, and shelter into “essential” expenses. While travel, entertainment, and charity would fall into the “discretionary” category. The thought is to cut "discretionary" expenses, if needed, during a bad recession.
"It's a recession when your neighbor loses their job; it's a depression when you lose yours." Harry Truman
However, if you cut out your “discretionary” expenses, it could be a devasting psychological hit. In fact, it may be unsustainable to even make these cuts in the first place because you would not be fulfilling your social and psychological needs.
Imagine not attending a good friend's celebration, foregoing your annual vacation, or resigning from your charitable involvement. You would be losing the activities that bring meaning and fulfillment to your life. After all, most social connectedness and inner peace lives in the “discretionary” category while basic survival expenses live in the "essential" category.
However, many traditionally defined “essential” expenses aren’t essential at all. From the house that is 30% bigger than you truly need, to the clothes or food that could be bought at much more cost-conscious channels, etc.
When the next recession occurs, it pays to have a plan in place.
The truth is that cutting out entire categories (i.e. travel, entertainment, etc.) instead of the spending within categories simply does not work and is not sustainable. The better approach is segmenting spending within each category. This is because we are social beings and have psychological needs beyond basic survival needs.
It may be more sustainable to reduce your annual vacation expense (“discretionary”) by 40% and trim back on household lanscaping and/or cleaning expenses (“essential”) than to cut out your vacation entirely. And it may be more sustainable to reduce the clothes budget (“essential”) than to completely eliminate a friend's wedding (“discretionary”).
The bottom-line is to determine the expenses you can and cannot live without. True discretionary and true essential expenses are different for everyone, and sometimes these are hard to parse out. One of the ways a financial planner can be helpful is by facilitating these important conversations.
Added 07/06/2019 by Jason Siperstein, CFA, CFP®