Economic Cycles and Your Financial Plan
Hi everyone, and welcome back to Melissa Making Cents!
It should not surprise anyone that we're living in strange times. As a CERTIFIED FINANCIAL PLANNER™ and financial coach, these peculiar times have brought a lot of questions from both friends and customers. Over the past few years, we've dealt with the coronavirus, murder hornets, war Eastern Europe, shortages, rising gas prices, and inflation. To some extent, these pieces of what we've dealt with work together to create a whole.
Often, people in the finance industry are trying to fit these puzzle pieces of time together to get a better view of a larger picture. The better that we can fit these pieces together, the better we can do our jobs and help you plan for your financial future and create a family wealth that you can build and pass on as a legacy (or to spend).
While attempting the impossible of viewing the future, nothing comes in handy better than knowledge. Therefore, to make as accurate a prediction as possible, financial planners and others in the financial field need to be equipped with knowledge of the past, present, and most importantly, a solid foundation of the economy and how it works.
In light of current events and the uncertainty in the air, we’ll be going back to the basics! So buckle up for a refresher course from Econ 101 while we discuss The Economic Cycle, its workings, and how to cope with it!
THE Economic Cycle
For starters, Investopedia defines economic cycle as, “The fluctuations of the economy between periods of expansion (growth) and contraction (recession)." So let's work through a small example to make things a little clearer and tangible. Close your eyes, wait – no, you're reading, don’t close them.
Instead of thinking of the economy as some crazy thing that no one can control or understand, think of it as something living. The economy can best be compared to a fictional animal called the Phoenix. In case you don't know, the Phoenix is a bird that is born from ashes, grows into maturity, and upon reaching the end of its life, bursts into flames only to once again be reborn from the ashes. This cycle continues to infinitely.
Similar to the Phoenix, the economy is something that doesn't necessarily have a start or an end date. Instead, it's something that just exists. It grows from small amounts of activity into something huge, booming, and robust. However, eventually, it reaches a tipping point and slows down to varying degrees. After this slowdown, the economy once again begins building upon itself; much like the Phoenix, this cycle continues indefinitely.
While the Phoenix is a great example to think about and illustrate the economic cycle, it's not a perfect comparison. Some economies are sick, and some economies are healthy. Healthy economies will experience more frequent and rapid growth, while sick economies will experience more time in slow down.
The Cycle’s Four Stages
Now that we have a big picture of the economic cycle let's start breaking it down into chunks! But, first, to study the economy, or even understand it, we need to understand that the economic cycle isn't thought of as one big idea. Instead, it's thought of in (typically) four broken down parts.
The four parts of the economic cycle are referred to as expansion, peak, contraction, and trough. We’ll get into what each of these means and work on understanding them in the next section. But for now, just remember the Economic cycle is the continuous life cycle of the economy, and it’s comprised of four stages or phases – expansion, peak, contraction, and trough.
Typically, these stages or phases follow this same order and pattern. As far as which, the economy starts on, that's more of a chicken or egg question. While this pattern can be identified and followed in the economic cycle, the severity or intensity of each stage may vary from economy to economy. This variance is defined by the health of the economy at the point in time when experiencing said stage.
The Four Stages Explained
As promised, let's start going over each stage of the economic cycle in a bit more depth. This will help us better understand the economic process and how it works and layout a rough idea of what we should be doing with our income and debt in each specific stage of the cycle.
Expansion can be thought of as the growth phase of an economy. During this period, an economy should experience faster and more intense growth than any other part of the cycle. However, the starting point of growth isn't necessarily important; times can still be relatively rough at the beginning of the expansion phase.
Peak marks the end of an expansion. During this stage of the economic cycle, the growth of expansion slows. This should be when the economy is experiencing maximum output. However, things aren't all good – a peak also typically creates some sort of friction in the economy (perhaps supply and demand become out of sync, causing prices to do strange things).
Just as peak can be considered the end of expansion, a contraction can be viewed as the end of peak. During contraction, the imbalances created during peak (caused by the friction we mentioned) reach a tipping point. This begins the process of what is known as an economic correction, where the economy starts rebalancing supply and demand into equilibrium (when supply, demand, price, and production are in sync). Unfortunately, economic correction can be pretty painful to participants in an economy, including regular people, business owners, and governments. During contraction, prices can be expected to either rise or stagnate, and unemployment will likely rise.
Trough is the lowest point of a contraction. This is when the economy has reached its slowest phase. It's a tricky spot for anyone attached to the economy – however, the good news is that expansion is (hopefully) just around the corner.
As a side note, perhaps the easiest way to think of the economic cycle and its stages is to think of two main phases: growth and slowing down. Growth is when expansion and peak happen and slow down is when contraction and trough occur. Expansion is the opposite of contraction, and peak is the opposite of trough. This idea can also be referred to as the boom and bust cycle, which many of us are familiar with after going through the great recession.
How YOU Should Deal with Stages of Economic Cycles
Dealing with the four stages of an economic cycle can be extremely tricky. Any financial advisor will tell you that there are definitely hard decisions to make, especially during economic slowdown in contraction, and trough phases. Working with a financial planner is one of the best ways that anyone who's not in the finance field can mitigate the risks of losing money and coming out on top following times of slowed economic growth. However, here are a few ideas of different approaches to economic cycles from a personal finance standpoint.
For Periods of Economic Slowdown:
First, shield yourself by creating a large emergency fund and budget. Building an emergency fund should be one of the first steps anyone makes for their financial future. However, it's even more critical during contraction and trough to have an emergency fund and budget available to you. With an emergency fund, you'll already have a plan to eliminate or lower monthly costs, which will give you more available money to live with. And having an emergency fund will allow you to deal with situations as they arise when you don't have the cash to cover them out of pocket. Picture this – money's tight because the economy is in a trough, but you have an unexpected hospital visit or lose your job. Usually, that would mean taking out tons of (high interest) debt. However, because of your emergency budget and fund working together, you're covered!
Next, work on eliminating debt – starting with whatever’s accruing interest fastest. There are different methods to go about cutting debt, and different advisors will tell you different ways to handle debt. However, the simple act of cutting debt is a great way to start. You don’t want debt hanging over your head while the economy is in a downturn.
Lastly, avoid taking out any unnecessary debt, making large purchases, or trying to gamble on the market. The last thing you'd want to do during an economic slowdown is to throw money down the drain. Likewise, you don't want to be taking on high-interest rates, debt, or risk losing large sums of money in risky investments. Instead, work on saving as much money as possible to beef up your emergency fund, making purchases outright in cash, and investing using a financial planner – who's well equipped to work through difficult economic times.
For Periods of Growth:
When times are good in the economy, there’s perhaps no better time to be thinking about the future and retirement! When times are rough, retirement may be the last thing on your mind – you could be scraping by month to month just to make ends meet. But you can't work forever, and that's why working towards retirement is an excellent use of your time and money when the economy is in a growth phase!
While the economy is robust, there's no better time to be investing and create wealth for you and your family. If you invest your money yourself, consider taking on the strategy of Dollar Cost Averaging instead of "playing" the market like a casino. Dollar-Cost Averaging strategies put a fixed amount of money towards long-term investments at regular intervals – no matter what the price of the investment is doing. This strategy ensures that over time, you're averaging your investment by buying less when it's more expensive and more when it's less expensive. By dollar-cost averaging, you're increasing the likelihood of making a solid return on investment.
Lastly, when times are good, there's no better time to create contingency plans. In other words, be the squirrel that nests away acorns for the winter. That way, when winter comes, you have savings to fall back on! Working with a financial advisor to create plans for an economic downturn is perhaps the best use of any person's time during expansion or peak stages of the economic cycle.
How Long Does Each Cycle Last?
That’s a tricky question, and here’s why. The average economic cycle has lasted about forty months since the 1850s. However, following the Great Depression, our government changed how it deals with economic cycles. Instead of simply allowing them to happen and take their course, the government does its best to minimize the effects of a slowdown through a concept known as quantitative easing or the pumping of currency into circulation. While some are vast proponents of dealing with economic cycles in this manner, others worry that it worsens and extends recessions when they finally happen because the market corrections can be more severe.
Either way, you look at it, these actions have has made the economic cycle's life course longer. The current economic cycle began in 2009 and has lasted for over 13 years. This is incredibly lengthy, and some experts believe we're still mid-cycle.
What Phase of the Economic Cycle are we Currently In?
This is yet another very tricky question. It’s sort of impossible to answer. As I said, many experts believe that we're still mid-cycle of our current economic cycle. However, others think that we're past that, and even more, others think that we're nearing a market correction.
Economic cycles are defined by looking into the past – that's the only way we can chart and identify when we were in each phase of the economic cycle. On a more personal level, it makes sense to do what fits you best monetarily. A financial planner or coach can help you make wise money moves based on your income, debt, interest rates, and the economy as a whole at any given point in the economic cycle.
If you want to work with someone who can create a financial plan that will help strengthen your bottom line at any point of the economic cycle, call or email to schedule an appointment with me. We can create a plan that grows your wealth in good times and protects it in bad times.
Until next time... this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.