Why Are There Phases of a Business Cycle?

The phases of a business cycle are easy to define. They are contraction, trough, expansion and peak (more on each in a moment.) What’s more important is how to use this information to make better investments and not lose your money unnecessarily. It also helps answer the question,” how should I invest right now?” In fact, I believe you can’t answer that question unless you really understand the business cycle. Let’s get to work.

The Four Phases of the Business Cycle

The first phase is contraction. This isn’t quite as painful as childbirth but pretty close. This is when things slow down. People are afraid so they spend less money. Companies stop hiring and start laying off people because they don’t have profitable work to assign them. That leads the economy to contract still further. People become more afraid so they tighten the belt even more. Companies have less income so they lay off even more people. It’s an ugly cycle and not a good tone. Since WWII, the average contraction lasted 16 months.

Trough phase of the business cycle

The next phase is the trough. This is when the economy hits bottom. Unemployment is at its highest level at this point. People are losing their jobs right and left. Companies’ profits are dismal, and many have closed their doors. Stock market prices are in the tank and the real estate market is languishing. In general, nobody is having fun.

When you are in the trough, it feels like it’s never going to end. If things get really bad, the economy dips into a recession or even a depression.

Expansion phase of the business cycle

But all things really do pass. The trough eventually ends and we enter an expansion. This is when people start buying more stuff. They do so because they’ve simply delayed their consumption as long as they could and now it’s time to replenish. Companies soon realize that they need to hire more people in order to make all that good stuff people are willing to buy. Since more people have jobs, there is more money in the system and spending continues to rise. That increases demand and companies can’t keep up with it. Prices rise and so do wages. The average expansion phase lasted 42 months since WWII – about 3 times longer than the average contraction.

Peak phase of the business cycle

At some point, we reach the peak but almost nobody knows it. In fact, like the trough, everyone expects this phase to last forever too. Demand is very high. Companies anticipate this so they hire lots of people and they fill their warehouses with big inventories. Everyone is spending like drunken sailors on a Saturday night (no offense to our good men and women in uniform. Everyone needs to cut loose once in awhile).

But at some point, the money is gone. Spending slows down. Companies are afraid of being stuck with all the inventory so the last thing they want to do is make more stuff. They start laying off people and that leads us back to the beginning – the contraction phase.

How Best to Use This Information to Make Smarter Investments

1. Understand that this cycle is inevitable.

As you can see, each phase inevitably leads to the next. Often the government gets involved. They can spend a great deal more money or cut spending in order to manipulate they cycle. They can raise or lower taxes and interest rates. If the government gets involved it can have a huge impact on how long and deep each phase can be but consequences are often unintended. Bad things can and often do happen if the government gets super involved. Regardless, the cycle is inevitable and one phase will eventually lead to the next.

2. Understand that nothing lasts forever.

As I said above, all things pass. Everyone around you will tell you that things are different this time and that the current situation (bad or good) is here to stay. When you hear people say this, do two things:

a. Send them this post.
b. Smile and walk away.

Regardless of how confident or depressed you and others may be, it’s crucial for you to know that the next phase is coming.

3. Don’t try to predict the next phase

While it is absolutely true that the situation will eventually morph into the next phase, it is impossible to know when that change will occur. Again, there will be people who try to convince you based on economic data that the next phase will occur at a certain point. Don’t fall for it. There are simply too many variables to predict the business cycle. While somebody might get it right once or twice, it doesn’t mean they really know. Remember, even a broken clock is right twice a day.

4. Make sure your investments and expectations are a good fit.

If you have an investment time horizon that is greater than 5 years, it’s very possible that you’ll have to ride through an entire business cycle. If you are investing for 30 or more years, you are absolutely going to go through a number of these cycles. This doesn’t mean you should necessarily buy and hold your investments during these cycles. I believe you can use effective market timing techniques to weather these storms more easily (but not perfectly). But at the same time, know that if you have short-term needs for your money, you should not make long-term investments in stocks or equities. That’s because you might need to cash in at exactly the wrong time. This is one of the top reasons why people lose money investing.

5. Don’t be a pessimist

The last point is that it doesn’t pay to be a pessimist. You may recall that the average expansion is about 3 times longer than the average contraction. That means the chances are higher (all things being equal) that the economy and your investments will do well rather than the opposite. The last 10 years have not been a very good example of this principle. But for me, that is just more reason to believe that the future could be exceptionally bright if you believe in reversion to the norm – that things eventually get back to normal.

Do you operate your financial life through the filter of the business cycle? Do you do anything differently as a result of which phase we’re in?