Navigating the ups and downs of the market can feel like a roller coaster ride. No matter if you're new to investing, or you've been doing it for a while, it's normal to have questions on how economic forces can affect your investments. Now, you may be wondering "What is a business cycle?" and “how do business cycles affect my investments”?

In this article, we'll take a deep dive into business cycles. We'll break down what they are and the factors that influence them. By the end, you'll be equipped to navigate the ups and downs of the market with confidence.

Get ready to explore what a business cycle is all about as you take one step closer to reaching your investment goals.

What is a business cycle?

A business cycle is the natural rise and fall of economic activity over time. It's like a rollercoaster ride that the economy goes through, with ups and downs that represent periods of growth and contraction. The cycle can be broken down into four phases: expansion, peak, contraction, and trough.

The expansion phase is when the economy is growing, with businesses hiring and consumers spending money. The peak is the top of the cycle, when the economy has reached its highest point and is about to start contracting. The contraction phase is when the economy is slowing down, with businesses cutting back on hiring and consumers spending less. Finally, the trough is the bottom of the cycle, when the economy has reached its lowest point and is about to start expanding again.

Understanding economic growth

Economic growth is a term used to describe an increase in the production of goods and services in an economy over a period of time. Essentially, it's a measure of how well an economy is performing.

When an economy is growing, it means that businesses are expanding. This is also when people spend more money, and there are more job opportunities available.

One way to measure economic growth is through gross domestic product (GDP). GDP is the total value of all goods and services produced within a country's borders over a certain timeframe, usually a year.

GDP vs. Real GDP

But, GDP doesn't tell the whole story. In particular, it doesn't take into account changes in the price of goods and services over time. That's where real GDP comes in.

Real GDP is an adjusted version of GDP that takes inflation into account. It's like comparing the amount of things we make and do this year to the amount we made and did in a previous year, while also considering changes in prices. This gives us a better idea of how much the economy is really producing.

If we only look at GDP without adjusting for inflation, it might not tell us the true story of how well an economy is doing. Prices can go up over time, and this can make it look like the economy is growing when it's not. Because of this, it’s important to understand how inflation affects our everyday lives and the value of money.

By using real GDP, we can get a more accurate picture of how much an economy is actually producing.

How business cycles impact investors

Business cycles can have a significant impact on investors. When the economy is in the growth phase, things are going well. Businesses are making more money and the stock market is usually up.

But during a contraction phase, also known as downturn or recession, things are not so good. This is when economy slows down, businesses start making less money, and the stock market often goes down.

As an investor, it's essential to understand where we are in the business cycle because it can influence how you invest your money.

The Reserve Bank of Australia predicts the country's economic growth in 2023 to slow down. This forecast is due to factors like increase in interest rates and living costs, and decrease in real wealth. Because of this, Australia's GDP growth is expected to be 1.5% in both 2023 and 2024.

On the other hand, Australia's job market is still competitive and tight. As a result, the unemployment rate is expected to remain at around 3.5% until mid-2023 before rising. Inflation was 7.8% in 2022. However, it is predicted to decrease to 2-3% in the future due to lower domestic demand and labor market conditions.

Understanding business cycles is important for investors to make informed decisions about where to invest their money. By recognising the current phase of the cycle, you can choose investments that best suit your investment goals and tolerance for risk.

What are the factors that can influence a business cycle?

It's not just important to know where we are in the business cycle, but also what factors affect it. This way, you can make smarter investment choices based on good information.

Here are some key factors to keep in mind:

1.Changes in consumer and business confidence. How confident consumers and businesses feel about the economy can affect the business cycle. These factors can influence spending and investment decisions of individuals and businesses.

When they feel more confident, they tend to spend and invest more. This can further lead to economic growth. But when confidence is low, spending and investment tend to slow down, which can cause a downturn.

2.Monetary policy. Monetary policy is the process by which central banks, like the Reserve Bank of Australia (RBA), manage the supply and cost of money in the economy.

When the RBA wants to stimulate the economy, it can reduce interest rates, making it cheaper to borrow money. This can encourage spending and investment, which can stimulate economic growth.

But, when the RBA wants to slow down the economy to prevent inflation, they can increase interest rates. This makes it harder and more expensive for people and businesses to borrow money, which can result in less spending and investment. In response, the economy can see a decrease.

Keeping yourself updated about monetary policies decisions can greatly help in understanding which phase of the business cycle we are currently in.

3.Government spending. Governments can also influence the business cycle through their spending decisions.

When the government pays for infrastructure projects like new roads and bridges, it can create more jobs and help the economy grow. But if the government stops spending as much money, it can slow down the economy.

4.Global economic developments. These developments refer to change in the economy of different countries and how they affect the world's economy. Additionally, they can influence the business cycle of individual countries.

For example, if one country is facing a recession or a downturn, it can cause less demand for goods made by other countries that trade with them. This can lead to a ripple effect of less economic activity, fewer jobs, and less spending in those countries.

But, let's say one country is having a period of strong economic growth. This can prompt other countries to produce more goods and services, which can create more jobs and help their economy grow.

5.Potential output. Potential output refers to the highest level of economic output that an economy can handle in the long run. It's influenced by different factors like how many people work, how much they produce, and how much money is invested.

When the economy is booming, potential output can be met or even surpassed. Such an outcome can cause inflation and overheating of the economy.

But, during an economic downturn, the actual output falls below the potential output. This leads to more people being unemployed and resources not being used enough.

As a long term investor, it pays to keep tabs on potential output. This is because it can have a big impact on how much money businesses make and how well the stock market performs.

6.Yield curve. The yield curve is a tool used to compare the amount of interest you earn on short term and long term investments. It helps us surmise whether the economy is heading for a recession.

When long term interest rates are lower than short term interest rates, it's called an inverted yield curve. An inverted yield curve usually predicts that a recession is on its way. That's because it indicates investors think the economy will slow down and interest rates will drop in the future.

In comparison, a normal yield curve is when long term interest rates are higher than short term interest rates. This means investors think the economy will keep growing, and interest rates will rise in the future.

Understanding the dynamics of the business cycle is specifically important for long term investors. This is because it can impact the performance of stocks, bonds, and other assets. By watching what's happening in the economy and following certain signs, you can make smarter choices in your investment journey.

What should long term investors understand about business cycles?

With long term investing, it's vital to pay attention to the current and future state of the economy and how businesses are performing. Understanding business cycles can provide us with this insight. By learning about business cycles, you can make smarter choices when it comes to investing and managing a long term portfolio.

As discussed in the previous section, business cycles can be influenced by a variety of factors. These factors can all impact the economy in different ways. They can also affect businesses differently depending on their sector and location.

As a long term investor, it's important to keep an eye on economic indicators like GDP growth, the unemployment rate, and the yield curve. These can give you a sense of where the economy is headed and help you identify potential turning points.

For example, if GDP growth is slowing and unemployment is rising, it may be a sign that the economy is entering a downturn or recession. However, if GDP growth is strong and unemployment is low, it may show that the economy is in an expansion phase.

Understanding the dynamics of the business cycle can also help you manage risk in your portfolio. For instance, you may want to diversify your investments across different sectors or locations. This can be a way to reduce your exposure to any one particular business cycle.

You may also consider investing in companies that don't depend too much on how the economy is doing. These can be companies that provide essential goods or services that consumers need, regardless of the state of the economy. This way, you can protect your investments from big changes in the economy.

Remember that there are many other factors that contribute to a company’s success. It is also important to do your research on how their competitive advantage can affect your investments in the long run.

Case Study: The 2008 Global Financial Crisis

The 2008 Financial Crisis is a good example of how knowledge of business cycles can benefit investors. It all started with the US housing market crash - and ended a worldwide recession.

Before the 2008 crisis, the US economy was growing. The government lowered interest rates to encourage spending. Back then, people were investing in packages of mortgages that were sold as investments. They were called mortgage-backed securities.

But this growth didn't last long and caused a housing bubble in which prices became too high to sustain. When the bubble burst, it caused a decline, which resulted in a recession.

One investor who was able to weather the storm of the 2008 crisis was Warren Buffet. He had long recognised the importance of understanding business cycles. With this, he had built his investment strategy around it.

He invested in companies that were strong, well-managed, and had advantages over their competitors. During the recession, he saw that companies were struggling in the difficult economic climate. But he knew that they had maintained sturdy long term prospects, so he invested in them.

At this time, Warren Buffett decided to invest in a company called Goldman Sachs. He believed that the company had a strong balance sheet, stable management team, and a solid business model. Even though things were tough for everyone at the time, he believed that Goldman Sachs would weather the storm and become even stronger.

To wrap up, knowing about business cycles is important for long term investors who want to make smart choices with their money. Although these cycles can be tricky to predict, they usually have a pattern. Being able to recognise where we are in the cycle can empower you to make better investment decisions.

Remember, though, that there's no perfect way to invest. Do your research to better understand the business cycle and what affects it. That way, you can make better choices about your investments while sticking to your goals. So whether you're new or experienced, understanding the business cycle is a valuable part of reaching your financial goals.

Happy investing!