Financial Lessons From the Great Recession | Extra Mile

Chances are, over your lifetime, you’ve heard lots of financial and money-saving tips from folks who lived through the Great Depression—the longest, deepest, and most widespread economic depression of the 20th century. During the Great Depression, personal income, tax revenue, trade, profits, and prices all dropped, and unemployment rose to as high as 1 in 4. Today, the Great Depression is used all over the globe as an example of how far the world’s economy can decline.

For most people who lived through the Great Depression, financial strategies focused on how to “make do” with very little. Advice from survivors of the Great Depression typically consists of ways to minimize household expenditures—such as by growing your own food, fixing your possessions when they break down instead of replacing them, buying items in bulk to minimize costs and generally learning to live on less. All in all, the lessons of the Great Depression largely emphasize balancing and managing household income and expenses, or what we think of as “home economics.”

How the Great Recession and the Great Depression Compare

More recently, the U.S. also experienced an economic downturn which many have called The Great Recession as a throwback to the Great Depression. The Great Depression began in 1929 and lasted more than 10 years. The Great Recession started in 2007, hit its nadir in 2009, and was largely over by the end of 2010—although its effects continue to be felt across the U.S. economy even today.

Technically, although there is no formal way to distinguish between a recession and a depression, two consecutive quarters of negative economic growth qualifies as a recession—whereas an economic depression sees higher unemployment and bigger drops in economic growth over a longer period.

Although both recessions and depressions are economic events that impact individual employment and household finances, the Great Recession and the Great Depression differ in important ways. The Great Depression started with the crash of the U.S. stock market, whereas the Great Recession can be traced back to the subprime mortgage crisis, combined with low interest rates and high levels of household indebtedness.

The subprime mortgage crisis, for its part, was a nationwide banking emergency triggered by a large decline in home prices after a period of strong increases, which lead to mortgage delinquencies and foreclosures and the devaluation of investments related to house values.

Why is it important to note the differences between The Great Depression and The Great Recession? In a nutshell, it’s because the lessons learned from each are quite unalike. Harry Truman famously noted that the difference between a recession and a depression is that “it’s a recession when your neighbor loses his job; it’s a depression when you lose yours.”

When the entire economy is deeply affected by an economic downturn—such as during an economic depression—then the advice for households is about how to minimize expenses and spending. But when fewer people and sectors are affected by a downturn—such as during a recession—then the lessons learned may be more about how to avoid the downturn and its impacts entirely.

Keeping that distinction in mind, here are three main lessons Americans learned from the Great Recession that are still relevant today.

1. When “Safe as Houses” Isn’t Safe

The Great Recession was spurred by a bursting of the “bubble” in housing prices across the U.S. In the years leading up to the recession, although it may have been difficult to see at the time, it is clear that many Americans either overspent on housing relative to their incomes, or allocated an overly-large share of their net worth to housing.

As a result, when house prices collapsed, households that were overextended on mortgage payments or overly reliant on the equity built up in their houses were caught up in the aftermath. They saw the value of their housing equity evaporate from their net worth and some defaulted on mortgages and lost their homes altogether.

How could these impacts have been avoided? The lesson goes back to the old adage, “Don’t put all your eggs in one basket.” If you concentrate a large fraction of your household balance sheet on a single asset, such as housing, you have little protection if that basket “breaks” (i.e., if the value of housing declines). Although we have long thought of housing as a “safe investment,” the reality (as the Great Recession demonstrates) is that even “safe” investments can carry hidden risks for your personal balance sheet.

2. The Dose Makes the Poison

The lessons about over-concentrating on housing can apply to any large allocation on your personal balance sheet. Recall that the Great Recession started with the bubble in housing prices bursting, but went on to affect investments that were themselves reliant on the housing sector, such as mortgage-backed securities. That’s how a decline in housing values led to a banking crisis, as the financial products that were closely tied to home prices fell in tandem with those prices.

What this meant in practice is that even households that did not overspend on housing may have been affected by the drop in housing values, as the impact of falling house prices spread through the U.S. economy to sectors well beyond housing. This ripple outwards affected the value of stock investments across the economy. What that meant for individual households, in turn, was potentially large and unexpected declines in net worth—even if the value of your personal residence didn’t fall, you didn’t have mortgage-backed securities, and you kept your job.

Even though U.S. stock markets have recovered over time, for many people the sudden shock of tumbling stock values in their personal investment accounts was a difficult challenge to overcome. As with housing values, many investors may have been lulled into a sense of security by rising stock prices, thinking that they were being rewarded financially as a result of taking the risk of investing in equities. However, the “risk-reward trade-off” of stock investments is not always positive: There’s no guarantee that if you take risk, you’ll be rewarded.

How could investors have protected themselves from the effects of falling equity markets? The medieval philosopher Paracelsus gave us the adage, “the dose makes the poison.” Although he was writing about medical conditions and cures, his advice could apply to personal balance sheets as well: Even if a little of something is good, a lot of something is not necessarily better.

That is, although equities have a higher expected return than bonds, that doesn’t mean that all of your dollars should be allocated to equities. Instead, it’s important to keep your “dose” of equities—or any single financial asset class—in moderation, so that you are not overly impacted if the value of that section of your balance sheet falls.

3. Look Through a Life-Cycle Lens

If you open a newspaper today, you’ll see that there’s general agreement that the U.S. economy has largely recovered from the Great Recession. Employment rates have gone up, and stock markets and house prices are recovering. Overall, the message is optimistic.

The underlying implication is that if you can “wait it out,” you’ll be fine in the long run. But what if you can’t wait for recovery? What if you planned to access the stored wealth in your house or your investment accounts during the midst of the recession? Many households across America faced restructured retirement plans as a result of the Great Recession—whether that meant delaying retirement altogether or altering their standard of living in retirement.

That’s why it’s important to look through a “life-cycle lens” at your personal finances, understanding that needs and approaches to personal finance will differ at various points in your lifespan. Put simply, what’s appropriate for a 20-something investor with several decades of work and wealth accumulation ahead of them is likely not right for a 50-something who’s thinking about leaving the workforce in the next decade. As your financial wealth grows over time and you get closer to retirement, the importance of managing the risks to your financial health increases.

The Great Recession demonstrated that many households were over-allocated to housing and to equities generally, but it’s important to understand that households at or near retirement felt the effects of the recession disproportionately. That’s because they had less time in the workforce to wait out the effects of the recession, to replace the money that was lost from their investment accounts and wait for asset values to recover.

Households approaching or in retirement will need to keep a close eye on ensuring the dollars they’ve stored to fund their retirement retain their value over time. What that means for you is to take care to view any investment advice you receive and any investment actions you take through a “life-cycle lens,” understanding the importance of how your strategies may need to change as you progress through the decades.

Bringing It All Together

All in all, the Great Depression and the Great Recession taught Americans different lessons about how to face financial challenges. The Great Depression demonstrated to the generations since, the importance of frugality and thrift, and how to keep a household together through a prolonged economic decline. The focus of these lessons is at the level of the household, the family and the community.

The lessons of the Great Recession, on the other hand, emphasize the importance of assessing the risks to your personal balance sheet and focused on how you can protect yourself when markets and economies don’t behave as expected—their focus is beyond the individual household, at the level of the economy and investment markets. Both sets of lessons are useful to promote financial health and well-being for Americans today.

Read More: 5 Emotion-Laden Situations That Could Ruin Your Retirement

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