The Importance of Business Cycles in Financial Planning
When it comes to financial planning, it's important to recognize what we can and cannot control.
We can control our own behavior, make thoughtful financial plans, and adjust our strategies as needed. However, we don't control the economic cycle, market movements, or policy decisions that impact the broader financial landscape. Recognizing this distinction allows us to focus on the aspects of our financial lives where our decisions truly matter.
With some investors now worried about a possible recession and the stock market facing heightened uncertainty, we believe it’s a good time to review the fundamentals of business cycles and how they affect financial planning.
What is the business cycle?
The economy goes through ups and downs over time, moving between periods of growth and slowdown. These cycles, known as business cycles, are measured by things like how much the country is producing (GDP), how many people have jobs, and how industries are performing. While the length of each cycle can vary, they typically last between 5 and 10 years.
Since World War II, the U.S. has gone through twelve recessions—times when the economy shrinks instead of grows. In the past 25 years alone, we’ve seen three major downturns: the 2020 pandemic recession, the 2008 financial crisis, and the 2001 dot-com crash. However, there have been plenty of times when experts worried about a recession that never actually happened.
Business cycles have generally gotten longer since the 1970s and early 1980s, when high inflation and slow growth caused economic struggles. From the mid-1980s until 2008, the U.S. experienced a period of steady economic growth, often called "The Great Moderation." During this time, the economy was strong, inflation stayed under control, unemployment remained low, and business cycles lasted close to nine years on average.
Phases of the business cycle
The economy goes through ups and downs, but there are common patterns we can recognize. These patterns are called business cycles, and they typically have four phases:
Expansion – The economy is growing, businesses are doing well, more people are getting jobs, and confidence is high. Companies may invest in new projects, and overall spending increases.
Peak – Growth hits its highest point. The economy is running at full speed, prices may start rising (inflation), and there could be signs of overheating.
Contraction – The economy slows down. Businesses may stop hiring or even lay off workers, spending decreases, and economic growth weakens or turns negative.
Trough – This is the lowest point of the cycle, where the slowdown bottoms out before recovery begins. Unemployment is usually at its worst, and confidence in the economy is low.
Each phase may not be equal in length, and there are both situations where business cycles last longer than some expect and cases where cycles end abruptly.
For example, during the 1990s business cycle, the economy slowed sharply in 1995 without falling into a recession. The Fed was able to achieve a so-called “soft landing” by lowering inflation without negatively impacting economic growth.
In contrast, the 2008 global financial crisis resulted in a swift economic decline due to a rapid collapse in the financial sector. The same is true in 2020 when the nationwide shutdown resulted in a sharp decline in economic activity.
Trying to precisely time business cycles is notoriously difficult. This is one reason economics is often referred to as “the dismal science” - it has a poor track record of predicting recessions, and often predicts ones that never occur. However, recognizing where we generally are in these cycles can help us make better financial decisions nonetheless.
Distinguishing between business and market cycles
Stock market ups and downs happen more often and can be more unpredictable than the overall economy. While the economy moves through longer business cycles, the stock market can have multiple drops (called corrections) within just one cycle. It's common for the market to have several short-term dips each year due to things like investor emotions, how much cash is flowing in the market, and other factors beyond the economy itself.
One reason for this is that the stock market looks ahead to the future, while economic reports show past data. Although the economy does impact the market, stock prices are also influenced by news, investor feelings, and many other factors. This can lead to overreactions, causing sharp ups and downs even when the bigger economic picture hasn’t changed much.
Financial planning through cycles
Instead of trying to guess the perfect time to buy or sell investments, these simple strategies can help you stay on track with your financial goals no matter what the market is doing:
Maintain a long-term perspective - Market ups and downs might seem big in the moment, but over decades, they’re often just small bumps in the road. Short-term drops don’t always mean a recession is coming. For example, the stock market fell in 2022, but the economy didn’t enter a major downturn.
Building a portfolio that aligns with your goals and rebalancing - Building a strong portfolio for tough economic times means diversifying your investments so you’re not relying too much on any one type of asset. Regularly rebalancing your portfolio helps keep your investments aligned with your goals by trimming overperforming assets and adding to those that have lagged, ensuring a balanced approach through market ups and downs.
Adjust expectations by cycle phase - During late-cycle periods when valuations are stretched, future returns may be lower. Consider moderating return expectations during these phases rather than chasing higher yields through excessive risk-taking.
Have an emergency fund - Market downturns happen, and having 6-12 months of expenses set aside can make a big difference, especially if your job or income is at risk. This safety net helps you avoid dipping into investments at the wrong time.
Portfolio resiliency across all phases of the business cycle
Constructing an appropriate portfolio remains the cornerstone of investing across business cycles. Different asset classes can respond in unique ways to changing economic conditions. For example, stocks typically benefit from economic expansions but struggle during contractions. On the flipside, bonds can generate income during expansions and provide portfolio balance during contractions.
The right portfolio differs for each person, balancing these asset classes according to your time horizon, risk tolerance, and financial goals. A well-diversified portfolio might underperform the hottest asset class during any given cycle, but it also avoids the most severe drawdowns that can derail financial plans.
Market and business cycles are natural parts of the investing experience. Rather than trying to predict each turning point, history shows that it’s better to maintain a well-constructed portfolio that can weather all parts of the cycle.
Process over predictions.
Shean