The word “recession” can trigger a lot of fear and anxiety for many people, especially after the traumatic experience of the Great Recession of 2008. But what does a recession really mean, and how should we prepare for it?

In this blog post, I will share some insights from the First Principles series by Paula Pant, a popular financial blogger and podcaster who teaches people how to achieve financial independence and live their best lives.

What is a recession?

A recession is defined as two consecutive quarters of negative economic growth, as measured by GDP. This means that the total value of goods and services produced in a country decreases for six months or more.

A recession reflects the state of the economy, not the stock market. The stock market can fluctuate for many reasons, such as investor sentiment, expectations, news, and events. Sometimes, the stock market can predict a recession, but other times, it can be misleading or lagging.

What causes a recession?

There are many factors that can contribute to a recession, but one of the most common ones is inflation. Inflation is the general increase in the prices of goods and services over time, which reduces the purchasing power of money.

To control inflation, the Federal Reserve (the central bank of the US) can raise interest rates, which makes borrowing money more expensive. This can slow down spending and investment, which can reduce economic growth and lead to a recession.

The Fed has a “dual mandate” to balance both inflation and the risk of recession, but this is not an easy task. Sometimes, the Fed has to choose between the lesser of two evils, or react to changing conditions.

Are we in a recession?

The short answer is: possibly. We won’t know for sure until we have two quarters of negative GDP growth, which can only be confirmed in hindsight. But there are some signs that suggest we might be heading towards a recession, or already in one.

For example, the Fed has raised interest rates five times so far in 2022, which could indicate that inflation is a serious concern. The stock market has been volatile, and some sectors, such as crypto and bonds, have been depressed. The global economy has also been affected by the pandemic, trade wars, and geopolitical tensions.

However, there are also some positive signs that indicate that the economy is still resilient and strong. For example, the unemployment rate is at a record low of 3.6 percent, which means that most people have jobs and income. The housing market is also booming, thanks to high demand and low supply. Consumer spending, especially on discretionary items like travel and dining, is also robust.

How should we prepare for a recession?

The best way to prepare for a recession is to think from first principles, which means to question our assumptions and biases, and to base our decisions on facts and logic.

One of the most common biases that we have is to assume that the next recession will be similar to the last one, or the worst one. This is not necessarily true, as recessions vary in severity, duration, and frequency. The Great Recession of 2008 was a rare and extreme event, caused by a housing bubble and a financial crisis. The next recession might be milder and shorter, or even unnoticed by most people.

Another common bias that we have is to panic and sell our assets when the market is down, or to avoid investing altogether. This is not a wise strategy, as it can lock in our losses and miss out on the recovery. The market is cyclical, and it tends to correct itself over time. The best strategy is to invest for the long term, and to diversify our portfolio across different asset classes, such as stocks, real estate, and entrepreneurship.

Finally, another common bias that we have is to focus on the negative aspects of a recession, and to ignore the opportunities that it can create. A recession can be a great time to start a business, as there is less competition, more talent, and more innovation. Many successful companies, such as Airbnb, Uber, and Netflix, were born during or after the Great Recession. A recession can also be a great time to learn new skills, network with like-minded people, and pursue our passions.

Conclusion

A recession is not something to be feared, but something to be understood and prepared for. By thinking from first principles, we can avoid the common pitfalls and biases that can cloud our judgment, and instead, make smart and rational decisions that can benefit us in the long run.

If you want to learn more about how to achieve financial independence and live your best life, check out the First Principles series by Paula Pant, and sign up for her free email series on real estate investing. You can also join her online community and listen to her podcast, where she interviews experts and ordinary people who have achieved extraordinary results.

Remember, you can afford anything, but not everything. Choose wisely, and live well.