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Understand the Business Cycle

This lesson is a part of an audio course Become a Self-Directed Investor by Damanick Dantes

One of the great things about economics is that it teaches you how the world works. And finance allows you to participate in the flow of money through the great economic machine. Productivity, capital, and labor are the major pillars of global growth, and they all move in cycles, which result in market swings that dictate portfolio gains and losses.

As a self-directed investor, you're already equipped with the tools and knowledge to set-up your global portfolio. Previous lessons taught you to set up a standard low-cost portfolio, built for the long-term. Along the way, you're allowed to make minor adjustments, which is what we call rebalancing. Our objectives might change, we could become more conservative as we age, or perhaps the economic climate has shifted.

On the latter point, economics plays a major role in asset class performance. It's all part of the global business cycle. It comprises four stages: early cycle, mid-cycle, late cycle, and recession. During the early cycle, the economy is recovering from a downturn which typically benefits cyclical sectors such as commodities, industrials, and consumer goods.

At this stage, there's a lot of pent-up demand, and maybe some government stimulus to get things moving again. This is when solid upside performance occurs for equities (especially emerging markets that benefit from increased commodity demand and international trade). Think of 2009, right after the financial crisis when the stock market bottomed out.

Mid-cycle is when the economy starts to level out and asset price returns moderate. This is typically when volatility picks up a bit as the market becomes uncertain about future growth prospects. Late cycle is when inflation starts to pick up, and we see the effects of an overheated economy. Stock markets tend to produce lower returns during this time period, and investors begin to hedge against potential losses with bonds and other income assets.

And then a recession hits, which is when sitting in cash is probably the best option until the recovery period. The good news is that recessions and market corrections don't last long relative to other cycles, which benefits long-term investors who can handle such risk.

There are many economic and market signals that help us anticipate business cycle shifts, but that's an entire course. To make things simple, you can use the CNN Fear/Greed indicator to know when market conditions are at either extreme, which can help you decide when to tilt your portfolio to more growth, more income, or more cash.

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Written by

Damanick Dantes

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