Economic Cycle: Overview and Stages
Key Points
- Economic cycles feature expansion, peak, contraction, and trough stages.
- Investors adjust strategies based on the current economic phase.
- Government tools like interest rates help manage these cycles.
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So many things in life ebb and flow, including economic activity. Poetic as it is, the economic cycle can be stressful if you don't understand what's happening as it makes its way through the ups and downs. Read on to learn more about this process.
The economic cycle is a process through which economic activity grows and shrinks in a relatively predictable pattern. Although the length of each period in the cycle isn't all that predictable, the pattern repeats again and again, so we can at least pinpoint where we are in it.
Factors like gross domestic product (GDP), interest rates, total employment, and consumer spending are examined and compared to one another to determine at what point in the cycle we happen to be. Expansion is a great time for businesses to grow and thrive, but contraction helps to consolidate and refocus economic activity. Both have their necessary place.
There are four basic stages of the economic cycle:
Economic cycles are managed by governments using monetary policy tools like interest rate changes, or alterations to deficit spending. Taxation is another tool to cool off a too-hot market, which helps to reduce spending and can create a budget surplus that can be used for all kinds of things, including paying down government debt.
Debt accrual due to deficit spending can help spark a new expansion period in an economic cycle by getting money flowing again. Taxes or interest rates may be changed to encourage business investment, which can cause a slow expansion of the economy over time.
For long-term investors, economic cycles matter a lot less than they do for investors with shorter investment time horizons. Foolish investors hold their investments through economic cycles because they're good businesses that can go the distance, rain or shine.
But we're all still people, and these rises and falls in the economy can have massive effects on our portfolios. Sometimes, it's important to understand where we are in the economic cycle so we can choose investments that can produce well even in a downturn, like utilities or consumer staples. Sometimes, economic cycles allow us to shop for bargains when the economy is cooling, including certain types of real estate investment trusts (REITs) or housing stocks.
Understanding economic cycles and where we are in them can help you make buying decisions that take advantage of the normal rises and falls in various cyclical industries. Although we still believe in dollar-cost averaging and small, incremental investments over time, when you can get stocks you were already going to buy at a discount, there's nothing wrong with that.