Boom and Bust Cycle

The boom and bust cycle is the alternating phases of economic growth and decline. It's another way to describe the business cycle or economic cycle.

According to the Federal Reserve Bank of Richmond, these phases are inevitable. The more you understand their phases, causes, and history, the more you can protect yourself from their effects.

In the boom phase, strong consumer demand is the leading force. Families are confident about the future, so they buy more now. They know they'll get better jobs, and their home values and investments will increase in value. This demand means companies have to boost supply, which they do by hiring new workers. Capital is easily available, so consumers and businesses alike can borrow at low rates. That stimulates more demand, creating a virtuous circle of prosperity.

If demand outstrips supply, the economy can overheat. Also, if there's too much capital chasing too few goods, it causes inflation. When this happens, investors and businesses try to outperform the market. They ignore the risk of bad investments to achieve gain. 

In the bust phase, the main force is plummeting expectations about the future. Investors and consumers get nervous when the stock market corrects or crashes. Investors sell stocks. They buy safe-haven investments that traditionally don't lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral and recession.

The bust phase stops when supply lowers prices enough to stimulate demand. It occurs when prices are so low that those investors who still have cash start buying again. 

The best way to protect against the boom and bust cycle is to rebalance your investment portfolio once or twice a year. It will automatically make sure you buy low and sell high. For example, if commodities do well and stocks do poorly, your portfolio will have too high a percentage of commodities. To rebalance, you'll sell some commodities and buy some stocks. That forces you to sell the commodities when prices are high and buy the stocks when prices are low.

Know the causes of recession so you can hedge your finances before it happens. Follow the top five leading economic indicators. Look out for signs such as high-interest rates. That could lead to declining home prices as sellers offset the higher mortgage costs. Another significant sign is a decline in durable goods orders.

Asset bubbles can be just as dangerous. There have been seven since 2005. They occurred in housing, oil, gold, US Treasuries, the stock market, the U.S. dollar, and bitcoin. Study them to make sure you don't get caught up in the next one.

thebalance.com