The Stock Market and the Business Cycle: Their Correlative Relationship

Many people think that investing in stocks is a surefire way to get rich and hit the jackpot.  The reality couldn’t be further from the truth.  See, the truth is that to get average returns that beat inflation, all you need to do is put it in an index fund.  Index funds will match the market returns of whichever market the index fund follows, be it the S&P 500, the Dow Jones, or the Nasdaq.  The market, on average, has been known to return an average of 10% per year.

The inflation rate has been historically about 3% per year.  That is a real return of 7% per year on your money.  And if you plug your expected returns into any compound interest calculator, you will come out with a nice number at the end of 20/30/40 years and see your portfolio grow year after year.  But stock investing isn’t a a linear progression like that; ask the people who lost 36% of their 401k during the credit crisis of 2008.   Here is the truth about stock investing.  It is a rough ride and goes through cycles just like the business cycle, going through periods of increases and declines. 

The business cycle goes through about one recession every 8-13 years.  And the stock market usually coincides with the business cycle.  And recessions can either last just months or go on for years.  So yes, in 30 years you can end up having pretty close to what you expected to get in return for your investment.  But that 30th year could also be the year where a really bad recession hits and you lose 20% of your total portfolio.

This picture perfectly illustrates the perception most people have of stock investing and the actual reality of stock investing:

Original image source

And if you notice, it is extremely similar to this illustration of the business cycle:

Like the business cycle, your portfolio will go through periods of troughs and peaks.  The much quoted annual return of 10% is not really an annual return. Rather, it is the average return over an extended period of time. Some years, you might lose 10% of your portfolio, and other years you might gain 20% on your portfolio.

But don’t think that the stock market is chaotic and a gambler’s game.  It is quite the contrary.  But the key however, is resiliency.  The stock market itself is resilient. It has proven over the past century to be one of the most profitable investments vehicles. From 1928 to 2013, the S&P 500 has returned an astounding 9.55% per year. No other type of investment has been able to return that much money over that long of a period of time. A $100 investment in 1927 would have been worth $255,5553.31 in 2013 if it followed the S&P 500 index.  Compared to a 10 year treasury bond, $100 in 1927 would have yielded only $6,295.79 in 2013.

The Truth About Stock Investing

So what exactly is the truth about stock investing?  The truth is that stock investing, over the long term has been proven to be extremely resilient at making people lots of money.  However, like any investment, there is also an inherent risk involved.  The risk is that you can lose a big portion of your portfolio at any given time if you are not careful.  And sometimes you won’t have a choice in the matter; the stock market reacts how it reacts.  The only choice you have is to either take your money out or ride through the tough times.  In the last two years before your retirement, the stock market index could be experiencing a rally that increases the value of your portfolio by 20%.  But the flipside is that the stock market could be retreat and you could lose 30% of your portfolio just two years to your retirement.

So how do you mitigate the risks and uncertainties of stock investing?  Well you can’t completely mitigate the realities of stock investing if you want to make a fair amount of money through the stock market.  However, what you can do is align your risk appetite with your goals.  In general, the younger you are, the more risks you should take.  So if you are in your 30s, you should be taking more risks than if you were in your 50s.  In addition, you can also try to learn how the economy works, and look at economic indicators to guide your investment decisions.  Although not precise, economic indicators tell a lot about the current or future health of the economy.