People throw around the word “recession” even more than “traumatizing” when I wear shorts.

But what actually are recessions? What causes them? How do they impact your finances? Are we headed for one?

Let’s break it down.

What is a recession?

A recession is when the economy slumps. It’s marked by falling production, employment, and spending. Basically, less money moving around the economy. If these characteristics are in place for at least six months, that’s a recession.

For example, in 2008, the U.S. faced a major recession triggered by the collapse of the housing market. Banks had issued risky mortgages, and when homeowners defaulted on their loans, it caused widespread financial distress. Stock markets crashed, millions of jobs were lost, and it took years for the economy to recover fully.

Recessions are challenging, but economies eventually bounce back.

• The average recession lasts about 11 months: Historically, recessions in the U.S. have varied in length. The longest, the Great Depression, lasted about 43 months, while others, like the COVID-19 recession, lasted only two months.

• Recessions are part of the business cycle: Economies go through regular cycles of expansion (growth) and contraction (recession). Since 1900, the U.S. has experienced about 33 recessions.

• Not all industries are hit equally: Some industries, like healthcare and utilities, tend to be more “recession-proof.” During economic downturns, people still need medical care and electricity, so these sectors often perform better than others.

What causes recessions?

Recessions are usually triggered by a combo of factors that put stress on the economy. These include:

• Decreased consumer spending: When people stop spending as much, businesses earn less and often cut jobs. For example, the COVID-19 pandemic caused a sharp drop in consumer spending on travel, entertainment, and dining out, contributing to a short but severe recession in 2020.

• Higher interest rates: Central banks, like the Federal Reserve in the U.S., raise interest rates to fight inflation, but this can make borrowing more expensive for businesses and consumers, slowing down investment and spending. In 1980, the U.S. Federal Reserve raised interest rates dramatically to curb inflation, which led to a deep recession.

• Financial crises: Sometimes, recessions are caused by the collapse of financial systems. The 2008 financial crisis, for instance, was sparked by the collapse of the housing market, leading to a global recession.

Recessions can also be caused by things like trade wars, political instability, or even natural disasters. Anything that disrupts the normal flow of economic activity can trigger a recession.

How does a recession impact you?

Recessions don’t just affect big corporations—they also impact you and me in several key ways:

Job losses: As businesses struggle to make profits during a recession, they often resort to cutting jobs. In 2020, the U.S. unemployment rate soared to 15% - the highest since the Great Depression!

Lower investment returns: Stock markets tend to fall during a recession, meaning your investment portfolio could lose value. During the Great Recession of 2008, the S&P 500 fell by nearly 57% from its peak, leaving many investors with significant losses.

Slower wage growth: Even if you keep your job during a recession, you may notice that pay raises are smaller, or nonexistent. Companies become more conservative with their finances, often freezing wages to cut costs.

Reduced access to credit: Banks may tighten lending standards during recessions, making it harder to get loans for things like buying a home or starting a business. After the 2008 financial crisis, it became much more difficult for small businesses to secure loans, stifling growth and innovation.

What should you do during a recession?

It’s normal to feel anxious during a recession, but there are steps you can take to protect your finances:

• Build an emergency fund: Having three to six months’ worth of living expenses saved up can help you weather periods of uncertainty.
  

• Diversify your investments: A diversified portfolio that includes bonds, stocks, and other assets can reduce risk. While stocks might fall, bonds often hold up better during a downturn.
  

• Avoid panic selling: It’s tempting to sell off investments when the market drops, but remember that recessions are temporary. The market historically rebounds over time, so selling at the bottom often locks in losses.
  

• Continue investing: Believe it or not, recessions can offer great buying opportunities. Stock prices often drop during a recession, meaning you can buy quality investments at a lower price. If you have a long-term perspective, investing during a downturn can set you up for future gains.

Are we headed for a recession?

There are a few signs that indicate whether a recession is incoming:

• Rising Unemployment: When businesses cut jobs, it's often a sign that economic activity is contracting. After hitting 4.3% in July (its highest level in 2.5 years, U.S. unemployment has fallen to 4.1%. Looking good there.

• Inverted Yield Curve: This occurs when short-term interest rates become higher than long-term rates, signalling economic uncertainty. This is not the case right now:

• Declining Consumer Confidence: When consumers feel less optimistic about the future, they spend less, which can slow down the economy. Consumers aren’t that confident right now:

• Falling Business Investment: If companies reduce spending on new projects, it suggests they expect slower future growth. That’s looking very strong right now:
  

  

• Decreasing Manufacturing Output: Reduced demand leads to lower production, which can signal an upcoming downturn. Looks like we’re back around all-time highs there too:

So, are we headed for a recession?

Looks like no for now.

Recessions aren’t the end of the world

While recessions can be tough, they’re a normal part of the economic cycle. Understanding why they happen and how they impact your personal finances helps you prepare for them, instead of fearing them. With a solid financial plan, you can navigate through any recession and come out stronger on the other side.

Besides! Doesn’t look like we’re heading for one right now anyway.