As we ride through the uncertainty of these first couple weeks of 2016 we need to wrap our heads around the complications of a market burdened by the energy sector. Particularly in this stressful time we should take a step back and look at some consistent patterns that the market displays throughout it’s cyclical nature. Later on we’ll discuss how you as an investor can be consistent and how that benefits your bottom line.
All world economies behave in a cyclical nature that follows a couple patterns. The first part of the previously mentioned cycle is massive expansion in economic power. Western Europe during the Industrial revolution, The U.S. after WWII, and Japan during the 1950s-1980s are examples of rapid exponential growth. These moments of growth are marked by increased savings by the average citizen, consistent rise in GDP, and low tax rates for industry and private entities.
To translate that into layman’s terms: economies go through cycles of growth. Those cycles of growth are driven by low tax rates on citizens. When the average worker can invest their money into the stock market, industries benefit. The extra capital companies accrue during times of growth are spent on improvements and increased production to meet demand. As the companies grow, the employees benefit with higher wages and more secure jobs. (Repeat)
Corrections are a vital part of this cycle because they keep the economy from growing too quickly. As companies and individuals start spending extra money during good times, they incur debt. Frequently both companies and the average worker will over-borrow from large banks. This excessive leverage is prevalent in rapidly expanding economies. People think the economy will continue to rise, and they’ll be able to make all of the money they just borrowed back. Things simply just don’t work that way.
Recessions and Corrections
As we talked about in last weeks article ‘Correction or Recession?‘ periods of time where the economy declines can be healthy. As the economy grows, companies grow faster than they can sustain. Equity prices rise disproportionately to earnings and P/E ratios become inflated. This inflation of equity prices make it much harder for the average person to invest in a significant way.
The beginning of a recession is marked by high P/E ratios, high leverage across multiple sectors, and falling industrial production. Essentially the growth that a company has propped up on debt and equity purchased by it’s employees falls out from under them. Investors exit the market in droves and companies have a hard time supporting their production. Jobs are cut, production slows, P/E ratios realign, and the economy cools for a short period.
Consistency in Your Life
Consistent growth is an investors dream but like we discussed earlier, the reality is we can’t always get what we want. What we can do however, is invest in a meaningful way at all points in the economic cycle. For investors new and old, setting up a budget and keeping to our savings plan are key to consistent, controlled growth.
Times of massive growth, like we discussed earlier, are not sustainable, and will be followed by a cooling off period or decline. Unrealistic expectations of continuous growth trick many investors into taking on more risk than they would normally be comfortable with. Set your risk window, and stick to it as long as your income doesn’t change.
Dollar-Cost Averaging is a method of reducing risk over a period of time while continuing to invest meaningfully. This reduction in risk is balanced out by a reduction in profits when the economy is expanding. Overall Dollar-Cost Averaging (DCA) smooths out the growth curve of an investors portfolio. Read more about DCA in our article Intermediate Investing: Dollar-Cost Averaging.
The main point I’m trying to convey is that the economy has inherent up and down periods. Investors need to understand that losing money is a part of making money in the long run. Long-term value investors looking to build a nest egg and have independent wealth should focus on creating consistent trends in their portfolio that will build wealth, but at the same time, curb risk.
I hope you’ve found this useful! If you have any questions or comments, feel free to leave them below (we love hearing from you guys), or email me personally at David.Coleman@Collegeinvestr.com. Thanks for reading!
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