What would it be like losing most of your savings overnight? Is it possible that the global economy controls your financial future? If so, what can you do when shocks to the economy occur?
- When Do Shocks to the Economy Occur?
- How Do Economic Shocks Affect You?
- Economic Shocks: Categories & Examples
- How to Respond to Economic Shocks?
- How to Prevent Economic Shocks?
- The Next Economic Shock
When Do Shocks to the Economy Occur?
One day, without warning, any of the following may happen:
- The market is down over 20% with no signs of immediate recovery
- Your credit score drops because your bank unexpectedly lowered your credit limit
- The corporation you work for announces layoffs, starting next month
Or maybe you were thinking of borrowing for a house, buying a car, or investing in a business. Months later, you find out it now costs more to buy it. If so, you might be in the middle of a global economic shock.
Economic shocks are unexpected events that alter the economy in a very short time. It happens by changing any of the macroeconomic variables, such as inflation, consumption, production, or employment. Because they originate outside the financial scope, they’re unpredictable.
Yet, that doesn’t mean you can’t prepare effectively. The first step is to understand when economic shocks occur:
- Markets are interconnected due to globalization. Whenever an industry affects macroeconomics, you can expect it to affect everything else
- The cause of the shock may have nothing to do with the market (e.g., weather, disasters, coronavirus…)
- Non-financial events may involve politics, monetary policies, terrorism, mass psychology, or technology
While economic shocks look negative in the short term, they work more like a market reset. Overvalued securities come back to “normal,” consumers become more mindful, and a new market cycle starts.
How Do Economic Shocks Affect You?
Should you care about the global economy? Some believe it’s more important than personal finance. Or maybe you believe you control your financial future regardless of the events.
While both are true, these shocks do affect your financial freedom (temporarily):
Impact on Your Retirement Accounts
Your retirement account is not that different from a traditional portfolio. It may include company stock, mutual funds, bonds, real estate, and annuities. And when market crashes happen, it will impact your retirement savings.
It’s not a big deal, as retirement plans are for the long term. If you’re withdrawing tomorrow, however, your finance is in trouble. The Government requires you to withdraw after a certain age, or else you pay double-tax plus penalties.
If the company takes care of your retirement, hope that it doesn’t go out of business.
Losses on Your Investment Portfolio
Nobody likes when your portfolio value drops by 40%. But it’s only a loss if you sell. You can hold and wait to break even.
The problem is:
- It may never happen (if you bought it at the top)
- You pay the opportunity cost for not investing in better assets
Notice the asymmetric risk-reward. If you lose 50% of $100, you need twice the money to recover (200% of $50), let alone profit. If you didn’t buy on the market floor, chances are even lower. And if your investment isn’t as liquid as the stock market (real estate, NFTs), your options are more limited.
Credit Limit Reduction
While the shock may not affect the average worker, consequences increase as you manage more money. Banks, for example, will reduce the available credit (without notifying you) to increase their cash flow. You may also find that lends offer smaller loans, need more requirements or ask for higher interest.
You should be able to restore your limit just by calling the branch. But if the bank is in a difficult situation, it may take weeks to restore.
If you don’t know about your new lower limit, you will overuse it, increase your utilization rate, and lower your credit score. Not ideal when planning big purchases.
Big Purchases Become More Expensive
Maybe you wanted to buy a house, but the owner has adjusted the offer due to inflation. Or you wanted to buy a car, but the company raised prices due to lower production. Or you’re starting a business, but the manufacturer raises the quote due to currency fluctuations.
If you choose to invest low-risk, such as bonds, you may find higher interest rates and lower prices. But there’s more chance that the company defaults on the payment.
The good news is, you’re not the only one who pays this extra. It doesn’t give you a market disadvantage. But has your income adjusted accordingly?
When it comes to global economic shocks, these consequences will reach everyone. Problems become more dramatic if you live in the area of the shock. And if you live in another country, these consequences may delay for weeks.
Economic Shocks: Categories & Examples
There’s no one way to prepare for economic shocks because each event is different. The market responds differently:
a. The trend may stay for 5+ years (so you’ll need to adapt)
b. The trend disappears next year (so you just bear and wait for it to pass)
c. The trend might be positive (so there are new business opportunities)
Instead of naming every event that may cause an economic shock, we’ll show three major distinctions:
#1 Supply/Demand Shock
When responding to economic shocks, it’s not about understanding the causes as much as the consequences. Before caring about what caused it, the priority is to see what’s next, if it affects you, and how to protect your finances. These consequences can either be on the supply or demand side.
During supply shocks, the offer is unable to meet the demand.
For example, production costs might increase. And if it becomes unprofitable, business owners may stop supplying altogether.
Or perhaps there’s a high demand spike, and the business is unable to produce enough on time. They respond to this scarcity with price increases.
Closely related to supply shocks, demand shocks correlate with consumption and employment. More money leads to more consumerism. If suppliers raise prices, it might cause a negative demand shock, which inverts the trend over time.
Sometimes, suppliers vary prices for essentials such as food, water, rent, and utilities. People will keep buying these no matter what, but that means they will cut other expenses.
#2 Positive/Negative Shock
Nobody thinks of economic shocks as something possible. It’s not that they don’t exist. They’re just unlikely to happen.
When was the last time the government policies positively affected the economy? When did production costs decrease rather than increase? What about mass consumption spikes, when frugality is the norm?
The only exception is technology.
Generally, anything related to innovation/inventions will improve production, create employment, and encourage consumption. So when dividing in positive/negative, technology shocks and economic shocks would be those opposites.
For example, Henry Ford created a technological shock, which leads to increased production. The Internet is another “shock,” increasing consumption and employment. As for negative shocks, the closest event is perhaps the oil crisis of 1970.
Any non-technological event would be an example of economic shock. The most relatable might be coronavirus, which leads to reduced supply, lower consumption, more unemployment, and inflation (after the Government responded by printing money).
To understand technology shocks, you want to look at (1) the technologies that shocked the economy in the past and (2) and revolutionary entrepreneurs (Elon Musk).
#3 Intrinsic/Extrinsic Shock
We’ve seen that while economic shocks may occur, no one may be responsible directly. If a natural disaster hits a production area, that will affect the national economy. If currencies fluctuate, suppliers will change their prices, and consumers may get more conservative.
We refer to extrinsic/exogenous shock when caused by out-of-scope events (accidents). It could be weather, terrorism, or like in 2020, a pandemic.
We refer to intrinsic shock when there’s a change in the financial “rules:”
- How many currencies trade for each other
- How the stock market is doing today
- How much cash flow/liquidity is available across banks and companies
- How inflation has increased compared to projections
- How fees and tax conditions change
While none of these affect the global economy directly, they affect how producers and consumers make decisions. Because these affect everybody, every sector will be affected, some sooner than others.
When hearing news about a particular industry, learn about the causes. If it was a financial shock, you know it may affect your sector, so now you can anticipate.
How to Respond to Economic Shocks?
By definition, shocks are fast and unpredictable. Even if you’re aware and prepared for them, they will catch you off guard. Many find this uncertainty stressful and worrying.
The question is when things don’t go as planned, what do you do to correct the situation? Even if you spot it too late, there’s always something you can do to better respond to the event.
And if the shock is positive, these suggestions will help you take advantage of the opportunity.
#1 Identify the Type of Shock
A financial decision is only good or bad based on the context. It’s the first step to understand your threat before taking action. Otherwise, you may make things worse.
It’s almost second nature to associate economic shocks with market crashes. You might think of selling your stocks, piling more cash, or checking the news for the 10th time. Instead, make simple questions to understand what’s really going on.
- Is it affecting the supply or demand?
- Is the effect positive or negative?
- Is the cause financial or non-financial?
Once you know, you make a decision based on the market stage.
#2 Identify the Market Stage
Whether it’s a global crash or a technological revolution, the world is always adapting. For example, the economic shock may start with denial/disbelief, followed by awareness, worry, and recovery. You can recognize these signs either by checking the news or stock prices.
For example, this graph shows how most people react to market swings:
Once you understand the pattern (the sooner, the better), you’re free from its influence and can use it to your advantage. If you spot it early, you can get out of the market before the bad news come. If you’re late and are already experiencing losses, it’s possible that the trend is already reversing, so there’s no need to take action.
How do you know? By looking at the causes of economic shocks. If it was an accident, you just need to wait for it to recover. But if it’s something permanent like technology, it’s time to adapt to new times.
#3 Identify the Affected Assets
When everyone is worried about economic downturns, it’s easy to overthink and make mistakes. Problems show up all at once, and it seems impossible not to lose money. Maybe you’re losing it already.
Now that you’ve identified the economic shock, the priority is to stop these losses:
- Inflation rising? Convert your money to inflation-free assets/currencies
- Investment portfolio losing value? Rework your exit strategy
- Lower monthly income? Consider side hustles
Depending on the market stage, you sell/buy to manage risk. The problem comes when protecting illiquid assets (such as real estate), which don’t trade fast enough to adapt to the market. Your best choice is to design a long-term, low-risk exit strategy.
#4 Understand the Trend and Anticipate
So you’ve identified the affected assets and stopped the loss. But just because you’re safe financially today, that may not be the case tomorrow. Especially in the early stage of the economic shock.
Find out what’s the most likely way you’ll lose money. When you find it, you should prepare for it while ignoring everything else. When done, you move to the next most urgent problem.
To better anticipate these problems, it helps to review other shocks that happened in the last decades. While each time it’s different, the patterns still resemble.
How to Prevent Economic Shocks?
How to prevent is a tricky question. Since shocks are unpredictable by definition, there’s no amount of preparation that will help you avoid them. However, if you create a solid financial strategy, you won’t have to.
Suppose you’re great at managing risk, have multiple income streams, and work on your financial intelligence. Like everyone else, you may suffer from mistakes and economic uncertainty. But because of your system, you barely experience any losses.
Imagine not worrying about the market. Prosper financially, even if the market becomes unpredictable. That’s the financial confidence you can create with the five following strategies:
#1 Apply Risk Management Strategies
Just as there are countless ways to make money, there are even more ways to lose it. Since risk is unavoidable, the goal is to win more often than you lose. Or at least, minimize losses:
- Emergency funds buy you time to manage risk. For example, 12-months of living expenses is enough for you to create a new income stream, an online business, or correct an investment mistake.
- Diversification limits how much you can lose. And if those assets have positive long-term projections, you’re lowering risk without reducing the reward. Even if you don’t plan on holding, diversification can save your money short term.
- Liquidity allows you to adapt your financial strategy as the market changes. You can trade your assets whenever you want, so you don’t waste time waiting for the market to recover. Liquid assets can protect your wealth and fund long-term investments, for a cost (e.g., higher tax bracket, income inconsistency).
- Offshore bank accounts can protect your wealth when the national economy is unstable. Some of the “safest” bank countries include Switzerland, Luxemburg, Sweden, Germany, Netherlands, Singapore, Canada, and Australia. These also offer more investment options, asset protection, and tax benefits.
#2 Get Rid of Debt & Illiquid Assets
There’s no worse time to be in debt than during a market crash. When the economy is going down, you want to have your money available, either to exit early or buy assets for cheap. Being in debt means you’ll have to work more for the same amount.
When you combine the debt pressure with an economic shock, it can paralyze borrowers from earning more income.
To get out of debt, you can:
- Consolidate your loans to protect your credit score
- Refinance with a low-interest loan to buy time
- Make money with side hustles that require almost no money or time
Illiquid assets (such as properties) are high-risk at uncertain times, as you don’t control the sale price. Your best bet is to sell when the situation improves. But if markets don’t recover, you’re stuck with those liabilities.
With enough cash flow, however, you can still keep these assets and do well. You can hold them for years until they profit. And meanwhile, you can acquire new liquid assets.
Do you own bonds, certificates of deposit, or retirement accounts? All these have withdrawal options, with their taxes and penalties. Depending on your investment size, selling might be worth the cost.
#3 Consider Recession-Proof Jobs
During financial hardship, you won’t be worrying about protecting your savings, but the money you’re not earning. Because without a strong income plan, saving doesn’t work. The good news is, you can work on your high-income career today (with no money, skills, or a degree).
During economic shocks, it may look like there’s less opportunity. In reality, the market need has shifted (not the demand). Recession-proof jobs have consistent demand, and during economic downturns, they may even rise.
That’s the case of public services, education, finance, and some technical professions (healthcare). And if you have an income skill and sell it the right way (business services), it will sell regardless. It’s also why most of these jobs pay per project/service and not for hours worked.
Add the fact that you can work from home, and you now have a flexible side hustle. You can pause it if you’re too busy with your main career. But when needed, you already have the basis and the demand to generate new income.
#4 Make Time for Preparation
Think of the last time something bad happened to the economy. Many lost money for being unprepared. Yet these same people claim that they “knew it would happen.”
In fact, most crises originate from problems that added up over the years, ignored by many. Maybe you can already see the next one coming. But what’s the point if you cannot protect your money?
You have to make time for preparation. A pause from work to look at where you’re heading. This feedback is the basis of financial growth.
Now, common sense is NOT common practice. Everybody is busy dealing with life’s events. If you don’t make it a priority, time will fly and leave you unready for the next economic shock.
#5 Improve Your Problem-Solving Skill
Your economic situation is the result of your decisions. You may think of it as careful planning. When in reality, the important decisions happen when the plan isn’t working.
Economic shocks are unexpected, which can cause confusion and stress. Under these emotions, it’s easy to make mistakes. So the way you react to the problem influences your success more than the event itself.
Assume you can grow your wealth in any economy if you find the right approach. And if the situation is too complex, start simple:
- What’s the most immediate problem?
- How can this economic shock affect me in the next months?
- Who is experienced enough to help me solve this problem?
- What does the market need that I can offer/learn?
- How can I minimize my losses?
Problem-solving is the most valuable skill in the market. As you get better at dealing with pressure, you eventually turn problems into solutions, which you can then turn into dollars.
The Next Economic Shock
Regardless of the economic shock, everybody has an opportunity. If you’re broke, you can take higher risks to increase your income. And if you’re wealthy, you’ll have more tools to protect your money.
Whether you’re at the end of the beginning of an economic shock, there’s always some preparation you can do to minimize losses. As long as there’s a market need, you can profit from any economy. Especially on technological shocks.